Italian Economy Watch

Monti, The Full Version

2012-01-18T11:44:00.000+01:00

The version in question is an interview with the Financial Times. A summary was available here, but now they have gone live with the whole interview. If you can raise it on Google or something then it is well worth a read. For one thing it will offer you a trip down memory lane. Anyone remember this? “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.” The reference is, of course, to former U.S. Treasury Secretary Henry Paulson, who famously used the remark in 2008 congressional testimony. But as Republican Senator Bob Corker pointed out in a subsequent hearing:

“I do want to remind you that the theory behind the bazooka was that if you have a bazooka in your pocket and the markets know that you have it, you will never have to use it. I would like to point out that you not only pulled it out of your pocket and used it, huge amounts of ammunition was pulled out of the taxpayer arsenal to solve that. I think you’ve done some very deft things and I compliment you on that, but the point is that things don’t always work out the way people, in their best efforts, think they’re going to work out.”

Well, the idea just surfaced again, this time from the lips of Mario Monti:

“I’m convinced, and the IMF is also convinced, that the more pledges are made [to the rescue fund], the higher the volume of pledges made, the smaller the probability that a single euro of cash will have to be disbursed.”

But, as former IMF Chief Economist Simon Johnson once explained, the latest version of the "bazooka" is unlikely to be any more successful than the previous one.

"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again. This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."

Fortunately the ECB has deep pockets, and as I argue in this post, these will probably suffice to keep short term bond yields down to acceptable levels, and help the banks fund themselves and recapitalise. What the ECB's LTRO's won't do is get new credit moving (one significant part of the initiative involves banks in the troubled periphery economies not having to write down the asset side too much too quickly, so there will be little room for "creative destruction"). As fund managers Bridgewater put it recently:

"We believe that a) there are logical limitations to the amounts of debt that creditors will choose to lend to debtors, b) at this time numerous debtors have passed their limits, and c) the projected rates of adjustment that policy makers are using, which generally mean slightly slower rates of increase in indebtedness rather than debt reductions, cannot happen. In other words, despite attempts of policy makers to push this debt expansion further, they can’t. Significant funding gaps will remain....... understandably, central banks are now trying to fill the funding gaps with abundant liquidity. At the same time, banks must contract and consolidate as they can’t adequately recapitalize."

Leaving aside the tricky issue of the extent to which the latest Euro management initiative will work, Monti does have more interesting things to say. He is, for example, quite positive about Standard and Poor's:

“If I ever dictated anything, it must have been what S&P had to say about domestic Italian economic policy,” he chuckles, before quickly correcting himself: “I never said the three letters BBB,” a reference to Italy’s new S&P rating of triple B plus........“It’s very interesting when they go through the various factors, and concerning the political risk factor they say there is one negative: ‘The European policymaking and political institutions, with which Italy is closely integrated’,” he says. “And then they go on, saying, ‘Nevertheless, we have not changed our political risk score for Italy. We believe that the weakening policy environment at European level is to a certain degree offset by a strong domestic Italian capacity’. “I think I’m the only one in Europe not to have criticised the rating agencies,” Mr Monti boasts.”

As Peter Spiegel and Guy Dinmore not unreasonably conclude, the reason for this positive tone is clear: "Mr Monti’s 60 days in office have been enough to convince the agency that his government is on a path of reform that could return the country to growth and shrink its debt levels, but that European Union mismanagement of the eurozone debt crisis is dragging down struggling countries, including Italy with its €1,900bn ($2,400bn) debt mountain".

"Over the course of the 90-minute interview, Mr Monti is careful not to challenge his counterparts directly. Asked whether the S&P analysis is a condemnation of Ms Merkel, who is widely viewed as the driver of the current response to the eurozone crisis, he is diplomatic: “I don’t think we can really single out one country or one person,” he says. Later on, when asked how concerned he is that strikes by taxi drivers and pharmacists could derail his reforms at home, he insists that when he wakes up in the morning, he is more concerned with “European leadership” than domestic unrest. “European leadership – not the German chancellor,” he quickly clarifies."

Italy Braces Itself For The Full Monti

2011-12-26T12:52:00.001+01:00

The Italian government, Mario Monti informed the country's parliament last Thursday, is now planning to concentrate its attentions on achieving economic growth. A timely decision this, since the statistics office announcement a day earlier that the country had once more fallen back into recession, while not being a surprise nonetheless does constitute a cause for concern. Not that Italy is any stranger to recession, since the country has now had five of them since entering Europe's Monetary Union at the turn of the century. In fact the Italian economy has now contracted in eight of the last 15 quarters, and GDP is back in the good old days of 2003, stuck below the level it first attained in the first three months of 2004. And of course it is now going backwards in time again. Depending on the depth of the recession now being provoked it is touch-and-go whether the economy might not at some point even revisit levels last seen in the closing years of the 1990s. And remember, this is not deflation ridden Japan, this is real, not nominal GDP we are talking about here. So far Italy hasn't been experiencing deflation, or at least not yet it hasn't.

All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don't have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.

Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.

Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.

Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004 and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won't be easy to address.

It's The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.

Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was - and has been for some years - on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs - like so many of the countries on the EU periphery - is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.

Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).

Retail sales have been falling since 2007.

And construction spending has been one steady slide down.

And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.

No Boom, No Bust

So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy's export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.

With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country's recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the "optimistic" camp on the question of the country's ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay's Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case the only way to compensate is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what "knife edge dynamics" really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels "lock in" - the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let's do another thought experiment. Imagine I am right, and Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy's case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn't the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian "coupling" with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be "bye bye Euro" (assuming the common currency still exists that far up the road).

It's All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the "knife edge trap" around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth - a factor the "structural reform answers all our problems people" don't seem to have given enough thought to.

The Monti government needed just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the "Full Monti" effect now seems to have been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB - with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy's rating to A+ on October 8) on December 15 to brace for a further debt downgrade after concluding that a "comprehensive solution to the eurozone crisis is both technically and politically beyond reach". And to complete the set, Moody's, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe's leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy's citizens who are subjected to the Full Monti, Europe's leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

The Policymaker's Fear Of The Italian Penalty Shot

2011-08-17T21:00:00.000+02:00

“While the impact of service-sector liberalization and privatizations may be positive on medium-term growth, the budget cuts are likely to have quite negative effects on the short-term GDP dynamic. We expect Italian GDP growth to slow to close to zero in 2012 and 2013.” Giada Giani, Citigroup

According to one anonymous German official speaking off the record to reporters from Der Spiegel, "a country like Italy can't be saved". We will have to trust that he was referring to the country's size when he made the statement, and not its existential core. If he was, he may well be right, at least under the Euro Area's current institutional arrangements. Let's take a quick look at why.

The ECB Backstop Works For Now

The Italian debt markets are a lot calmer this week than they were the week before last. Evidently there is a simple explanation for the phenomenon, and that is that the level of Italian bond yields is now more or less completely guaranteed by the European Central Bank (the ECB). Systematically and meticulously, the Italian ten year bond yield is being maintained at or around the 5% level by a team of dedicated bond traders in national central banks dotted around the Euro Area.

The process whereby this result is achieved is not that dissimilar to other more common central bank interventions, for eaxmple to target a certain exchange rate, or a given overnight interest rate. Basically, when the yield rises above a given threshold the ECB's representatives simply step in and buy bonds. This happened last week to the tune of some 22 billion euros, with bonds being acquired from a set of 5 EU peripheral countries, although we don't know how the purchases were broken down at national levels. One thing was for sure, there were a hell of a lot of Italian bonds tucked in there somewhere.

The problem for the bank now is that once you initiate a programme like this, there is no easy way to stop. Despite many voices who argue the contrary, Italy's problem is not simply a short term liquidity one (funding a deficit), it is a long term solvency one (servicing an enormous pile of debt and growing at the same time). While the country has long maintained a primary surplus, the weight of the debt has drifted steadily onwards and upwards. Italy is caught in a conundrum. With low growth you need inflation to be able to make the books balance, but this excess inflation makes the country's competitiveness problem steadily worse. If you implement the reforms needed to make the economy more competitive then you don't get the inflation, and if you take away the deficit in the meantime then you simply don't get growth. This is a zero sum game in which all the numbers don't add up.

At the push of an ECB "buy" button, Spanish and Italian sovereign bonds have effectively been taken out of the markets, and it is now hard to see how (without some sort of restructuring or other) they can now ever get back in again.

In ceding to pressure from Europe's leaders to take this decision, the central bank has now gotten itself locked onto the horns of a huge dilemma, and they are going to have great difficulty finding a way to extract themselves from it. Monsieur Trichet has lodged his finger well and truly inside the wall of the dike, and should he even momentarily take it out again, the whole structured could easily rupture, with many of the things we now know and love getting carried away in the ensuing flood.

Of course, the mere threat that he might one day do this does serve to concentrate all the various minds involved, but what is involved is a form of brinksmanship which could in itself one day become a problem.

A glimmer of what the bank is now getting itself involved in can be seen in last week's ECB balance sheet reading, since it grew to the year-to-date high of 2.073 trillion euros last, largely as a result of increased lending to eurozone financial institutions and additional sovereign bond purchases.

The balance sheet was up by 68.736 billion euros over the previous week, and 119.94 billion euros over the same period one year ago. In part the balance sheet surge was due to an increase in net lending to credit institutions (which increased by 98.3 billion euros to 393.3 billion euros). And in part it was up due to the 22 billion euros spent in bond purchases. Curiously the weekly fixed term deposit levels remained unchanged at 74 billion euros (the quantity spent in periphery bond purchases to date), which sort of settles the issue of whether the bank were going to "sterilise" the new purchases, or create additional money to pay for them. For the time being at least they seem to be doing the latter, since going by the size of the banks current account holdings (which jumped to 286.783 billion from 159.814 billion euros a week before) they seem to have offset the purchases through money creation.

Basically central bank bond purchase intervention is deemed to be "neutral" in monetary policy terms if an equivalent quantity is drawn back from the banking system by attracting new term deposits at the central bank. That the bank may be carrying out a "money printing" exercise (and especially one to monetarise the debt of certain countries in particular) is raising fears of impending inflation. My feeling is that, in the context of heavily over a leveraged private sector and congenitally weak domestic demand, this is not a real concern at present for the Euro Area. I think the ECB's own inflation alert was always overdone, since most of the inflation we have seen of late has either been imported (via rising energy and commodity prices) or adminstratively generated via consumption tax increases. There has been very little in the way of second round effects.

The real worry then should not be inflation, but whether or not the Italian government will ever be in a position to honour the bonds in full, and on time. At the present time this is only a theoretical question, since additional bond purchases can always enable the Italian state to meet its obligations, with the ECB facilitating debt rollovers by using the commercial banks as proxies in the primary markets. But just how deep in do you want to get? At the present time the bank owns something like 20% of outstanding Portuguese, Irish and Greek debt. 20% of Italian debt would be something like 380 billion euros, a volume of bonds which would already be difficult to pass over to the EFSF (or its heir the European Monetary Fund). But in this case the force of tradition is not strong, and there is no real reason why the bank need stop at 20%. The sky could be the limit, and the ECB could be transformed into the new Bank of Japan, effectively light years away from the earlier visions of the Bundesbank founding pioneers. And, of course, we would all be into one of those processes which can go on for just as long as they can.

The Balanced Budget Ammendment

At the heart of the recent ECB decision lay something known as the balanced budget ammendment. First introduced in Germany in 2007, this is a constitutional change which (in the German case) makes a deficit of over 0.35% of GDP illegal as of 2016. One of the conditions the ECB imposed on Italy was that they also change their constitution, but in this case outlawing deficits as of 2013. Effectively, and at a single stroke, this brings to an end a whole era of Keynesian counter-cyclical fiscal policy and economic management. So the implications are large, and hard to separate from the rapidly ageing population phenomenon.

While it was the size of the latest package of cuts which hit the headlines (Rome orders €45bn in cuts and taxes), the key issue was really the balanced budget ammendment, since this has one clear implication: as of 2013 there will be no new bonds. So at least now the outer limit of ECB exposure is a known fact.

Chronicle Of A Crisis Long Foreseen

While the Italian crisis may have crept up on markets all at once and unexpectedly, issues about the sustainability of Italian debt are not new. As FT Alphaville's James Coterill noted when the latest wave in the Italian crisis broke out: "In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. It was always Italy. High-debt, low-growth, Italy".

Exacty, Italy was always the greatest worry on everyone's minds, including the ECB's. Indeed, the now long forgotten minimum rating requirements for collateral posting at the bank were first muted by them with precisely Italy in mind. I myself wrote one blog post after another (see links below) warning of the danger which was looming, buried in Italy's toxic combination of low growth, rapidly ageing population and high accumulated debt. It was simply a crisis waiting to happen, and now it has. As the New York Times' Landon Thomas noted in the Blog Prophet of Eurozone Doom article he wrote about my work, "Mr. Hugh’s demographic thesis is not airtight: in fact, it was Italy, not Greece, that attracted his early attacks. But Italy, perhaps because its overall debt level was already so high and its population was older, pursued a policy of greater fiscal rectitude than its neighbors and avoided a real estate bubble".

Not airtight, but nearly-so it seems, since behind the short term obsession with fiscal rectitude there lie the longer term preoccupations about solvency and debt. And here Italy (and eventually Japan) jump right back into the cockpit. As Landon mentions, Italy didn't have a housing boom worthy of mention, so private debt didn't surge during the first decade of the century, and during the crisis Finance Minister Tremonti pursued a policy of flying under the radar by keeping deficit spending low. But now short term deficit issues are waning, and longer term solvency questions are surfacing in the wake of the renewed Greek crisis. Thus, while historians of the future may well struggle to understand just how it was that a simple fiscal deficit bailout programme was so badly handled that Greek sovereign debt shot up from around 110% of GDP entering the crisis to around 170% by the end of the "rescue" period (and this without even having enjoyed a real housing bubble, ie with a private sector that was not massively in debt), the Italian case will raise few eyebrows, since every thinking economist had seen it coming for so long (Japan too, see my Italy blog here, here, here and here).

Low Growth and Ageing Workforce Are A Troubling Backdrop

Italy's problem is not its fiscal deficit, in fact in every year since 1991 Italy has run a cyclically adjusted primary balance (that is before interest payments are taken into account), it is the weight of the accumulated debt burden and low growth. The country's trend growth rate has been falling for decades, and during the first decade of the present century it only managed to grow at an average rate of about 0.6% per annum.

Even though the quarterly GDP growth rate accelerated slightly in Q2, and reached a quarterly rate of 0.3% (up from the 0.1% expansion achieved in the first three months of this year), the slowdown in core Europe, and the readings on the most recent PMIs leave little doubt that the respite will be short lived. At this point even the current IMF forecast for modest 1% GDP growth in 2011 is looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.

The worrying thing is how Italy has been able to get so little growth out of so much. This is especially the case when you take into account the fact that during the last decade the country's labour force grew steadily, following the arrival of several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).

During this time the labour force grew by about a million:

while employment was up by around 1.5 million.

Yet GDP barely rose. In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption. The ideal combination would be to see both output and employment growing in tandem, but with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".

Slamming The Debt Brake Pedal Down To The Floor Won't Work

Despite the fact that the real leverage M Trichet now has over the Italian government is being exercised in order to obtain the constitutional change required for the balanced budget rule to be put in place, the severity of the fiscal tightening that Italy will now experience should not be taken lightly. In the first place something like 45 billion euros in new cuts will be implemented in 2012 and 2013, and this will be on top of the previously agreed package of 47.8 billion euros in cuts between now and 2014 agreed in the July budget.

In addition Italy will now aim for a general budget deficit no greater than 0.2% of GDP in 2013 (Germany will not achieve this result till 2016), and will maintain that ceiling into the indefinite future. Basically, this will mean the post 2012 Italian budgets will need to aim for an average primary surplus of just under 5% of GDP during the subsequent years, as the weight of the debt is gradually ground down, and the burden of interest costs reduced. This is a difficult, but not impossible task.Between 1995 and 1998, when Italy’s undertook its maximum effort to enter the monetary union, the average primary surplus was 5.0% of GDP. However, during the second half of the 1990s Italy was benefiting from both decreasing interest rates and also from the depreciation of the Lira. In addition the Italian government also implemented a significant privatization programme which helped to reduce the debt/GDP ratio. Most of these positive tailwinds will not be available this time round.

As Deutsche Bank analyst Marco Stringer puts it: "While there are no doubts that Italy needs to maintain a very prudent fiscal policy, there is a risk that an excessive fiscal consolidation could be counterproductive were it to have a significant negative effect on growth".

There is a very real possibility that Italy's fiscal consolidation, like Greece's, is so sharp as to be counter-productive, with the low inflation, low growth and revenue shortfalls making it extremely difficult for the country to reduce to debt to GDP level, even if the ECB maintains 10 year bond yields around 5%. Writing in the Financial Times, International Monetary Fund managing director Christine Lagarde makes exactly this point. “We know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustments must resolve the conundrum of being neither too fast or too slow. Shaping a Goldilocks fiscal consolidation is all about timing. What is needed is a duel focus on medium-term consolidation and short-term support for growth and jobs", she said.

So we really do now have a very high risk stand-off, with Monsieur Trichet and his colleagues holding the whip hand for the time being, as the threat to take the finger out of that dike concentrates attention on the issue in hand. But this upper hand has a definite sell-by date looming if the implementation of the debt-brake principal in a context of global slowdown (or recession) proves too severe for Italian voters to accept. Then the Italian politician's fear of the penalty shot from someone on his own side might just become stronger, despite his apprehension before the technical superiority of M. Trichet's footwork. In which case, someone should remind them over at the ECB that, as Paul Krugman puts it, "once once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors". As the United States discovered in Vietnam, it's easy enough to get yourself bogged down in a mess, but a lot harder to extricate yourself from one subsequently.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Going Dutch - One Possible Solution To the Euro Debt Crisis?

2011-08-16T21:29:00.000+02:00

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing -- after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago -- ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe's leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor's to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet's third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe's financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe's banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained "no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong".

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:

“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.

The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No..., No..., No..., No..., No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states -- and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.

The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone -- as it is now -- might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.

So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.

The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.

In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke.

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.

This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title "The Euro and the Scalpel"

Appendix - The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I'm German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.

These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.

Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.

It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Recession Warning On Europe's Periphery

2011-07-25T18:30:00.000+02:00

As Europe’s leaders struggle to convince markets that their Greek debt problem-resolution-proposals are actually viable, and will really do the trick, last week's flash PMI readings seem to have attracted rather less attention than they might. Nonetheless, the fact of the matter is that it is steadily becoming clearer that the current slowdown in Eurozone economic growth is turning into something more than just another one of those pesky “soft patches”. The pace of economic expansion in core Europe has slowed dramatically, falling back in July for the third consecutive month, according to the latest flash PMI. Commenting on the flash results Chris Williamson, Chief Economist at Markit said: “The Eurozone recovery lost almost all of its momentum in July, recording the weakest growth since August 2009 when the recovery first began. Excluding the financial crisis, the July survey was the most downbeat since the Iraq war in 2003, and consistent with a flat trend in quarterly gross domestic product.

In fact the rate of expansion – the composite indicator registered just 50.8, only slightly above the dividing line between growth and contraction - was the lowest since August 2009, when the recovery was just starting out. More importantly (for the longer term) new business coming in showed only a very marginal increase in July, registering what was the smallest rise since demand for manufactured goods and services first started to return to growth back in September 2009. Levels of incoming new business fell in manufacturing for the second month in a row, declining at the fastest rate since June 2009 – with new export orders actually falling for first time since July 2009.

What this means, of course, is that the slowdown has now extended, spreading deep into the heart of the core, with both services and manufacturing in both Germany and France affected.

The German composite index fell to 52.2, from 56.3 in June, and while the latest reading still remained comfortably above the 50.0 no-growth value, the month-on-month index fall of 4.1 points was the largest since the November 2008 post Lehman drop. Tim Moore, Senior Economist at Markit said in his report “Almost in the blink of an eye, German private sector output has gone from rapid growth to a slow crawl.

But even as growth in the core economies approaches stall speed, out on the periphery a new recession seems increasingly on the cards, and most importantly in countries like Spain and Italy which have so far managed to keep their heads just above the waterline. Growth in the second quarter of the year looks likely to have been minimal in both cases, and the outlook for the third quarter suggests we are entering a bout of economic shrinkage.

The PMI readings also coincide with the impression offered by monetary indicators.

As Henderson Global Investors’ Simon Ward points out, in late 2010, while real (ie inflation adjusted) current bank deposits were contracting in Spain and Italy, they were still growing robustly in both Germany and France, implying a solid economic growth economic outlook in the core for the first half of 2011 (this monetary indicator is often thought to give an indication of activity with a 6 month lag).

But currently, as can be seen in the above chart (which shows rates of six monthly growth) real deposits have even started to contract in the core, while in Italy the rate of shrinkage has accelerated considerably, suggesting that the earlier “two-speed” Eurozone recovery may now be about to give way to a period of much more generalised weakness, reinforcing the impression given by the PMI order indexes. What is most striking is the way Italian M1 deposits have been contracting much more strongly than Spain’s have of late, although this development should not take us completely by surprise, since, as I have been consistently pointing out (see here, here and here) it has been clear from both real and survey data for some months now that Italy was heading towards recession again.

And looking at the second monetary chart that Simon provides, it is evident that the weakness in Spain and Italy forms part of a much more general contractionary phenomenon on the periphery, but then I imagine that the idea that Greece and Portugal might be in recession comes as a surprise to no one.

Part of a Bigger Global Picture

Of course, the vulnerability we are seeing on Europe’s periphery is being played out in the context of a global economy which is itself clearly losing momentum. This generally weakening in global growth has been clear from the evolution in the global manufacturing PMI for some time now.

And the latest China manufacturing flash PMI (which showed contraction for the first time since the middle of 2010) suggests the ongoing pattern will be once more confirmed in July, with global manufacturing moving closer to the critical 50 dividing line which marks the frontier between growth and contraction.

Even more importantly the Chinese export order component (which could be considered as a long leading indicator giving us information about possible activity levels three to six months from now) reinforced the idea that the slowdown is likely to be extended in time.

This impression (of an extended period of lower growth globally) is also confirmed by the business expectations component of the German IFO. I would about anticipating an early termination of the slowdown till we see some real sign of sustained improvement in Chinese new export orders and a solid uptick in IFO expectations.

So Why Don’t We All Be Just That Little Bit More Vigilant?

Where does all this that leave Europe in policy terms? Well, in principle recent developments in the real economy should present the ECB with significant monetary policy dilemmas, given the risks to the integrity of the monetary union that could result from a combination of reform/recession weariness out on the fringe and bailout fatigue in the core. Evidently the slowdown will make it harder to meet deficit targets in Spain and Italy, and will most likely mean there is a need for new measures which will become harder and harder to sell to voters, while any deterioration in the jobs market in Germany (we should be watch the unemployment numbers in Germany in the coming months) could well make bailout contributions harder to drum up. As John Hussman put it in a note to investors this morning:

"As I've noted several times in recent months, bond market spread imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It's Different, "Overt domestic default tends to occur only in times of severe macroeconomic distress." The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbours at a cost to their own citizens".

So in theory what these leading indicator readings should be telling us is that we should expect little more in the way of rate rises during what remains of 2011. Continuing to raise rates into an economic slowdown where there are clear risks of financial instability would not seem to be sound monetary policy.

In addition, given the way the pace of manufacturing input price inflation now seems to be cooling rapidly (see chart below), it would not be surprising to see a change the wording of the risk assessment for price stability from ‘on the upside’ to ‘balanced’ at the next meeting. This would avoid a lot of potential communication difficulties in the months to come, and would open the door up to a much more flexible interest rate policy.

One critical point to grasp is that the ECB decisions themselves have now become one of the main factors which will influence the outcome of the slowdown, not simply via the standard monetary policy path on Europe’s core economies but via the impact its decisions will have on policy sustainability on the periphery, and though this channel on the level of global risk sentiment.

In this sense ensuring economic growth is not the only distraction which could divert the ECB’s attention from its principal mandate in defence of price stability, since there is also debt stability to think about too. Recent days have show that large peripheral economies like those of Spain and Italy, far from having totally decoupled from the smaller and weaker countries, are now once more being drawn back into the maelstrom.

In particular Italy’s government debt to GDP level of 120% has been attracting growing attention. Simple calculations show that just to stabilise debt at this level with the previous prevailing interest rates the country needed a 3% annual growth in nominal GDP. Now, of course, they are likely to need slightly more. But real GDP growth this year will be significantly under 1%, while all those earnest efforts by the ECB to push the country’s inflation rate down below 2% will simply serve to help nudge the debt level upwards, in the process raising the premium investors will ask to buy Italian debt, with the implication that next year the country will need an even higher rate of nominal GDP growth, and so on, and so forth.
And the situation is Spain is hardly better, with 85% of mortgages being attached to variable rates, pushing Euribor upwards simply starts to weaken the hitherto comparatively robust performance of the bank mortgage books, while the slower economic growth will make government deficit targets even harder to maintain.

So really, the issue is not whether the ECB was right to go ahead with this months rate rise given its main mandate, the issue is whether members of the Governing Council could by any chance prove themselves sufficiently flexible in the future to change their discourse in the face not just of Greek default woes, but also of heightening recessionary and debt management risks? In his report just before the last rate meeting, Deutsche Bank’s Gilles Moec argued that the situation was “not bad enough” for the Bank not to raise. I wonder if the deterioration we have seen since that time makes it “now bad enough”? Just how bad do things have to get for us to reach that point, and just what is prudent and what is risky behaviour in current circumstances? Certainly Council members need to be vigilant, but in particular they need to be vigilant that their attempts to avoid one problem do not inadvertently generate another, even more difficult to handle, one.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Can Italy Grow Its Way Out of Debt?

2011-07-03T19:33:00.001+02:00

What follows is simply a follow-up note to my earlier (Elephant in The Euro Room) piece on Italy. The decision by S&P to put Italian sovereign debt on negative outlook, and the subsequent announcement by Moody's that it was considering a downgrade has been widely commented on by analysts, and it might be interesting to take a look at some of the views that have been advanced on either side of the argument (although for the detailed analysis see me earlier post). But first, a summary of the problem.

Chronicle Of A Crisis Long Foreseen

The first thing to be absolutely clear about is that this issue is not new. As FT Alphaville's James Coterill notes: "In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. It was always Italy. High-debt, low-growth, Italy".

As the New York Times' Landon Thomas noted in the Blog Prophet of Eurozone Doom article he wrote about my work, "Mr. Hugh’s demographic thesis is not airtight: in fact, it was Italy, not Greece, that attracted his early attacks. But Italy, perhaps because its overall debt level was already so high and its population was older, pursued a policy of greater fiscal rectitude than its neighbors and avoided a real estate bubble".

Not airtight, but nearly-so it seems, since behind the short term focus on fiscal rectitude there lies the longer term preoccupation about solvency and debt. and here Italy (and eventually Japan) jump right back into the cockpit. As Landon mentions, Italy didn't have a housing boom worthy of mention, so private debt didn't surge during the first decade of the century, and during the crisis Finance Minister Tremonti pursued a policy of flying under the radar by keeping deficit spending low. But now short term deficit issues are waning, and longer term solvency questions are surfacing in the wake of the renewed Greek crisis. Thus, while historians of the future may well struggle to understand just how it was that a simple fiscal deficit bailout programme was so badly handled that Greek sovereign debt shot up from around 110% of GDP entering the crisis to around 170% by the end of the "rescue" period (and this without even having enjoyed a real housing bubble, ie with a private sector that was not massively in debt), the Italian case will raise few eyebrows, since every thinking economist had seen it coming for so long (Japan too, see my Italy blog here, here, here and here).

The Knife Edge Problem

The issue in hand is not too hard to grasp, even for those little tutored in economics. Italy's gross public sector debt stood at approximately 120% of GDP in 2010. This is already too high, since it is significantly past the critical 100% level widely considered to be "the point of no return if not handled carefully" one. And how did it get there is the question we may want to ask. Was the high debt level due (as is the case in Ireland) to an emergency bank bailout, or was the country struggling (the Japan case) to fend off entrenched deflation?

No, there were none of these exceptional (or mitigating) circumstances to take into account, we are simply faced with a series of governments that were persistently (and mainly due to the burden of accumulated interest charges) paying out more than they were receiving in income, for over more than a decade, and turning a deaf ear to all the warnings being offered. It is always heartening to hear Mr Tremonti telling us that he will clamp down on administrative excesses and politicians salaries, or that he will wage a war on tax evasion, but really it would be interesting to know why he is always just on the point of doing something decisive to solve Italy's revenue raising issues, but somehow never actually does.

As the Irish Finance Minister Michael Noonan said in an interview at the weekend:

"In Ireland, if you decide to tax bar stools and you give that instruction to the Revenue Commissioners [tax authorities] there will be a tax and there will a yield," he said. "Their collection does not seem to be very good and it is a matter of speculation as to whether they can fulfil the commitments they are making or not," he added.

He was talking about Greece, but Italy obviously suffers from similar tax collection issues when it comes to tracking down the informal economy.

Basically, the Italian case is something of a hybrid one, since it is a bit like Portugal in its inherently low trend growth rate (significantly under 1% per annum) and like Greece in the tax execution problems it faces. In common with all the Mediterranean countries it also faces a great challenge when it comes to getting politicians to set aside party-politiking in order work together in the common national interest.

So Italy is now in the hot seat, since the focus of investor attention is moving beyond short term deficit control problems, and towards long term debt sustainability ones. Italy, as Barcap's Antonio Garcia Pascual put it, is on the "knife edge".

And basically this isn't going to be a story which needs a very long timeline to resolve, over the next few years either Italy's public debt level will move downwards to 118%, 116%, 114% of GDP etc (and people start to breathe more easily) or it will carry on up towards 122%, 124% and 126% etc, in which case Italy will need to seek shelter in the new European crisis mechanism (if things hold together for long enough for it to be put in place), and the debt will have to be restructured (the Euro was a costly little experiment, now wasn't it?). This is the basic gist of the argument behind Moody's recent announcement that they were thinking of downgrading the Italian Sovereign rating, since the risks that Italy is going to need restructuring are rising.

Of course what really put the cat among the Italian pigeons, was Moody's subsequent announcement that it was putting 16 Italian banks on rating watch negative for possible downgrade due to their exposure to the Italian sovereign. Thus, in the blink of a press release was put to the test and found wanting a nice little theory that held that Italian public debt wasn't such a big deal, since it is mainly held by Italian banks. Exactly, and precisely for this reason it is a big deal for Italian banks, at least two of which could be considered systemic. Hence the debacle on Friday on the Italian bourses.

So as Garcia Pascual says, Italy is sitting on a knife edge, or looking out over a precipice. Really there are only three things that matter - the rate of GDP growth, the rate of inflation, and the level of interest payments. Unfortunately for Italy, the first two of these are falling at the moment (see this piece on current risks to Italian growth), while the third is rising. Just last Friday, following the news that Moody's were reviewing the rating of the Italian banks, the spread on Italian 10 year bonds over equivalent German bunds hit 213 basis points, a Euro era record.

As I have already stressed in the "Elephant In The Euro Room" piece, it is nominal GDP (or the sum total of real GDP plus inflation) that matters, and on existing interest rates the sum total of these two needs to be on average around 3% simply to maintain the debt were it is. Looking at the growth position, and the waning inflation as the global economy turns down, this level is unlikely to be achieved in 2011, so we will have our first evidence of "slippage". The longer term problem is that these two variables, in the case of an economy like the Italian one, work in opposite directions, since (given that Italy's economy is by and large export dependent for growth), in a currency peg structure more inflation means less peer-economy competitiveness, which means less growth. As Goldman Sachs economist Kevin Daly put it in a recent report:

“For countries attempting to address these twin imbalances (government debt and current account deficit) within a currency union, there is a ‘Catch 22’ situation: competitiveness can only be regained via real exchange rate adjustment (i.e., by running lower inflation than the Euro-zone average). However, in order to boost public sector finances, economies need stronger nominal GDP growth and, thus, relatively low inflation (or deflation) has the effect of exacerbating the public-sector deficit problem. In other words, it is difficult to address one imbalance without exacerbating the other, and vice versa”.

So that's the first part of the problem. But there is more. If we go back to Garcia Pascual's original baseline scenario chart, he assumed that the spread on Italian government debt would be about 100 basis points, in which case a nominal GDP growth rate of just under 3% and a budget deficit of just over 3% would stabilise Italian debt at around 120% of GDP. But the Italian spread just moved over 200 basis points, and in a post Greece-restructuring-event environment it is likely to go up, and not down, in which case, instead of stabilising, the debt will veer upwards, just on the increased country interest risk element alone.

Then again, you might say, Italy could go for a serious austerity programme (of the Estonian "let's show these guys we're serious" type), going well under the 3% deficit target, and even trying to obtain a general budget surplus. Surely this would bring the debt down, and increase investor confidence (thus bringing the spread down). Well, yes, it might raise confidence but look what has just happened to Greece and is happening to Portugal now. Apply more austerity to a fundamentally uncompetitive economy and you are liable to seriously reduce growth, and even send the country into quite deep recession (Italy is, in my opinion, already near slight contraction). On top of that you have the danger that along with the austerity you will introduce another "indignados" movement, something which is more or less predictable in Italy's deeply divided political environment. At which point the Euro would surely be "rockin and rollin".

All of which takes us back to the structural reforms issue as the great white hope on which so many people stake their bets that Italy will see it though.

Of course, whether markets will continue to provide Italy with sufficient financing depends not only on macroeconomic and fiscal fundamentals, but also on factors that are outside of Italy’s control (such as investors’ appetite for European debt). The country’s outstanding level of public debt is high and fiscal discipline in the recent past had been preceded by less controlled public spending. And although economic activity in Italy has been sluggish, we continue to believe that the government’s stated goal of continuing to impose fiscal discipline will suffice to keep the country on a sustainable debt path.
Natacha Valla, Goldman Sachs

"In an environment of low nominal growth, Italy‟s high interest payments (of around 5% of GDP) will continue to weigh on debt dynamics. However, we expect the primary balance to turn into a surplus from 2011 onwards, which should help to stabilise the debt to around 120% of GDP over the next two years.Having said that, determined action to implement growth-enhancing reforms and further fiscal consolidation to reduce the structurally high expenditure components is essential".
Lavinia Santovetti, Nomura

We agree with S&P, as we stated several times in Focus Europe, that Italy needs to intensify its efforts on structural reforms to boost its disappointing GDP growth. It is important that the strength of the private sector does not become an excuse for complacency. Productivity-enhancing reforms would increase the likelihood of meeting the post-2013 Government’s fiscal objectives......Given that fiscal consolidation remains a fairly consensus strategy across the main parties and the tangible strength of the Italian private sector, we remain positive about the stability of the Italian public debt. The key risk in the short term is a political mistake in dealing with the European peripherals.
Marco Stringa, Deutsche Bank

Of course, it is always a worthy option to live in hope, but looking at the evolution in Italian trend growth over recent decades, mightn't we do better all assembling in the Piazza San Marco one afternoon and getting down on of knees for half an hour, just to show we were really earnest in our hope.

The key thing about all these ardently solicited structural reforms is that they need time both to implement and to work, and time (as I explained above) is just what Italy now hasn't got a lot of at this point (debt to GDP will either go up, or come down, and if it starts to go up.....).

Back in June 2005 (when there was still plenty of time) the ECB hosted a conference with the interesting title "What effects is EMU having on the euro area and its member countries?" Among the papers present was one from two OECD economists (Romain Duval and Jørgen Elmeskov). The title of the paper was "The Effects Of EMU On Structural Reforms In Labour And Product Markets", and the key finding was that:

"As concerns the role of the monetary policy regime, the absence of monetary policy autonomy seems to be associated with lower structural reform activity in large, more closed economies".

Put in plain English, in a country like Italy, monetary union had slowed down rather than speeding up the much needed structural change. At the time of publication the paper caused quite a stir, but, like so many useful things, was soon forgotten. As if foreseeing the paper's fate, the authors close with the following lament: "It would be sad if structural reform were eventually driven by a factor that empirically is strongly correlated with reform: crisis."

Life it seems is inherently sad, and here we are now 6 years later, in the midst of the correlate they foresaw as their downside scenario, and still battling with all the same old problems, where the only light we can see at the end of the tunnel is that of the next express train hurtling down the track towards us.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Is Italy Not Spain The Real Elephant In The Euro Room?

2011-05-22T15:53:00.000+02:00

Looking through the latest round of EU GDP data, one thing is becoming increasingly obvious: when it comes to future monetary policy decisions at the ECB, and to exactly how many more interest rate hikes we are going to see, then the performance of the Italian economy is going to be critical. The growth pattern now is clear enough: Germany and France move forward at a lively pace, while the so called "peripheral" economies (Portugal, Ireland, Greece, and Spain) either remain in or continually flirt with recession. They are constrained bythe combined burden of their lack of international competitiveness, their over-indebtedness and the contractionary impact of their austerity programmes.

In this sense, given its size, Italy is in a key position to tip the balance between core and periphery one way or the other. And the fact that, growth in the Italian economy seems once more to be grinding to a halt is not good news in this sense, with the quarterly gowth rate falling back from a quarterly 0.6% in Q2 2010, 0.5% in Q3, 0.1% in Q4 and 0.1% again in Q1 2011.

Slow Growth Champion?

I suppose it shouldn't really have surprised anyone to find that Italy’s GDP growth rate continued to slip back in the first three months of this year - both in absolute terms and with respect to core Europe - since Italy's average growth rate during the first decade was only about 0.6% per annum. It shouldn't have surprised, but I'm sure it did, since the financial markets have only been thinking of how comparatively low the Italian deficit has been since the start of the crisis, rather than worrying their heads off about how a country with such a low growth rate and such a high pending elderly dependency ratio is ever going to pay down the already accumulated debt. Italy's debt to GDP ratio is currently just short of 120%, while the population median age is 45, so lets just say Italy is Japan without the current account surplus.

Now were the quarterly GDP growth rate not to accelerate beyond the 0.1% expansion achieved in the first three months of this year, then even the current IMF forecast for modest 1% GDP growth in 2011 would start looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.

Some Do Not Also Rise

The Italian result contrasts sharply with the strong performance in the main components of core Europe, emphasising yet again that despite the fact that it is managing to stay clear of bond market wrath at the moment, Italy essentially forms part of the low-growth high-public-sector debt economies on Europe's periphery. Both German and French real GDP growth in Q1 2011 came in much stronger than expected, with the former posting an impressive 1.5% quarterly increase (6% annualised), significantly stronger than the 0.9% expected by the markets, while French GDP increased by 1.0%, in this case with a strong contribution coming from domestic demand which was reflected in a strong increase in imports, imports which in theory should have benefitted Italy.

France and Germany are in fact Italy’s main trading partners, accounting between them for about a quarter of Italy’s total exports. So although we do not have a breakdown of Italian Q1 GDP yet, the above developments point to a stagnating domestic demand only partially compensated by stronger net exports.

The most recent results mean that German GDP has now passed its pre-crisis peak, while Italian GDP is still stuck at the level it reached at the end of 2004. The chart below (which comes from a recent report by PNB Paribas economist Ken Wattret ) shows the path of constant price GDP in the four largest eurozone countries (plus the UK) relative to where they were in Q1 2008. France is in a similar position to Germany, since fourth quarter 2010 GDP was around 1.6% lower than its pre-crisis peak, and it just rose by 1%.

The picture in the other countries, however, is very different. In Italy, Spain and the UK, GDP is currently 5.2%, 4.3% and 4.1%, respectively, below the peak levels reached in Q1 2008. So what accounts for the differences? In the German case the strength of the rebound is in-part a by-product the exceptional depth of the recession there. Between March 2007 and March 2008, German GDP collapsed by a cumulative 6.6%. This compares with peak-to-trough GDP declines of around 3.5% and 2%, respectively, during the recessions of the early 1990s and during the first years of the present century.

The Italian Economy Resembles The German One, Consumption Is Weak And Growth Depends On Exports: Unfortunately The Italian Economy Is Not Competitive Enough For This To Work

Germany’s strong export dependency, and consequent high sensitivity to fluctuations in global trade, is the key reason why the country goes from strong growth to deep recession and back again (in fact quarterly GDP growth in Q1 2008 was 1.4%, just before the economy fell into recession). This dependency is reflected in the unusually high share of GDP which is accounted for by exports (over 50%), and may well be associated with the unusually high median population age of 45.

As can be seen in the chart, the cumulative contractions in GDP in the other large European economies were typically significantly smaller than in Germany, even in a country like the UK which was extremely vulnerable to problems in the financial sector. A similar picture can be found in the US, where problems in housing and the banks formed a central and archetypical feature of the global crisis, even though GDP declined by only a cumulative 4% from peak to trough, two-thirds of the German drop.

On the other hand, the Italian case offers an evident exception to the idea that the harder they fall the steeper they rise. The cumulative decline in Italian GDP from its Q1 2008 peak to the Q2 2009 trough was nearly 7% - making the output loss bigger even than that experienced in Germany.

But the rebound has been much less impressive than the German one, with GDP still nearly 5% below the pre-crisis high, and basically still on the level of Q4 2003. In large part, this situation is a result of the weak performance of Italian exports. In Germany, exports are now back above their pre-crisis peak, while in Italy exports are still more than 14% under their Q1 2008 high point (See chart).

Productivity Is The Key

Average quarterly growth in German GDP since the economy bottomed in Q1 2009 has been nearly 1%, while in Italy, it has averaged under 0.3%. The geographical composition of German and Italian exports is one factor which influences the relative export performance between the two countries. The share of German exports which go to faster growing developing markets like China, has accelerated sharply since outbreak of the crisis, while Italy is still largely dependent on developed - and heavily indebted - economies. In addition Italy has a major competitiveness problem. Incredibly, and according to Eurostat data, in the first decade of this century the Italian hourly productivity index only climbed by 0.75%, while the German one climbed by 13.3%. That is to say, German productivity was up an average of 1.3% a year over the decade, while Italian productivity barely moved, rising only 0.07% a year. As a result, rising wages meant that Italian unit labour costs surged sharply. So, during the first decade of the Euro the Italians paid themselves more for producing virtually what they were producing at the start of the century. Naturally this is not sustainable.

Labour Inputs Shoot Up, But Output Doesn't

The situation is even more incredible if you take into account the fact that during these years the labour force grew steadily, and the country received several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).

During this time the labour force grew by about a million:

while employment was up by around 1.5 million.

In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption, the ideal combination would be to see output and employment growing at a healthy pace, with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".

Naturally, this lack of competitiveness is to be seen in Italy's deteriorating external position, and the drag on growth which this causes is seen clearly in this current account deficit and GDP growth comparison.

Exports have been growing rapidly since the middle of last year, but imports have been growing even more rapidly, and hence the goods trade deficit has widened considerably.

Growing Your Way Out Of Debt?

Aside from the impact on Italian living standards and welfare services, the big issue which arises from Italy's low and declining long term growth outlook is what this is likely to do for Italian plans to reduce the burden of its outstanding government debt. Is, for example, lower than expected growth likely to jeopardise Italy’s achievement of its deficit target for 2011? Well, if there was no increase in spending to compensate for the economic slowdown (and remember, Prime Minister Berlusconi's party just did very badly in regional and local elections) then the knock-on effect on the deficit would probably be small and probably not a large enough change to seriously call into question the Italian government's commitment to its fiscal policy targets given that the 4.6% deficit achieved in 2010 was 40bps below target and that the Government is aiming for a 2.7% deficit by 2012.

But Italy's problem has not been its high deficit level during the crisis, it is the high debt level the Italian government has accumulated over the years, and the continuing under-performance in growth terms means the government may well struggle to turn the situation round, and that some sort of restructuring (soft or hard) at some point may well be needed. Let's take a look at why.

According to OECD data, while Italy ran cyclically adjusted primary deficits (that is deficits before including interest payments) every year between 1970 and 1991, the country has run cyclically adjusted primary surplus every year since 1992 - even during the depths of the recent crisis. Thus Italy’s cyclically adjusted primary balance (as a % of GDP) has been in better shape than the balance of many of the largest developed economies. Notwithstanding this, the weight of debt as a % of GDP has continued to rise. So, while Eurostat recently confirmed that the Italian 2010 public deficit was 4.6% of GDP, and 40 basis points below the Government target,the debt to GDP ratio was revised up to 119% (in this case higher than the Government’s target number). What makes the difference is the impact of history and the weight of the accumulated debt, since interest needs to be paid on the debt.

Ambitious Targets Which Will Be Nearly Impossible To Achieve

Now Italy has set itself the objective of reducing the overall deficit below 3% of GDP by 2012. Indeed, the government’s 2011 Economics and Finance Document (EFD) sets itself extremely ambitious targets for fiscal policy. The objective is to achieve a broadly balanced budget by 2014 through the achievement of a deficit/GDP ratio of 3.9% in 2012, 2.7% in 2013, 1.5% in 2013 and a 0.2% in 2014 and (as the document says) “so on systematically increasing the primary surplus to continue on the path to reduce the public debt”. The aim is to maintain the fiscal balance within a range which is compatible with reducing the debt. But just how realistic is this objective?

Well, to make a comparison, back in March, ECOFIN proposed quite far-reaching changes to the current Stability and Growth Pact (SGP). In particular the Finance Ministers proposals included the incorporation of a principle of extra fiscal effort for heavily indebted countries – a principle which has become widely known as the "debt-brake" condition. According to the new proposal excess debt, i.e. public debt above 60% of GDP, should be reduced by 1/20th per annum. This new debt-brake condition has important implications for heavily indebted countries who have so far escaped the full force of market attention, such as Belgium and Italy, since these two have to deal with debt to GDP ratios hovering around 100% and 120% respectively. What is surprising about the fiscal path proposed by the Italian government in its EFD is that it appears even tougher than that implied by the new EU debt-brake condition.

Of course, assuming Italy meets its fiscal deficit objectives - which naturally imply no counter-cyclical stabiliser deficits during recessions (is this really realistic??) - the key variable to watch for the debt/GDP ratio is nominal GDP. Now Italy managed to achieve nominal GDP growth of around 4% a year in the decade before the crisis, and a rough and ready calculation suggests that with nominal GDP growth of around 4% debt to GDP would be down under 100% following the Econfin criteria, and under 95% following the Italian government's own EFT.

Catch Me (Out) If You Can

But is a 4% growth in nominal GDP realistic for the rest of this decade? It is important to remember that the composition of the earlier 4% average annual growth, since only around 1% of it came from real GDP growth, while 3% came from inflation. And, of course, during this time, as we have seen, Italy lost considerable competitiveness with Germany. So what may help with one thing (debt to GDP) may be positively harmful to another (international competitiveness, the current account defecit). As Goldman Sachs economist Kevin Daly put it in a recent report:

"For countries attempting to address these twin imbalances within a currency union, there is a ‘Catch 22’ situation: competitiveness can only be regained via real exchange rate adjustment (i.e., by running lower inflation than the Euro-zone average). However, in order to boost public sector finances, economies need stronger nominal GDP growth and, thus, relatively low inflation (or deflation) has the effect of exacerbating the public-sector deficit problem. In other words, it is difficult to address one imbalance without exacerbating the other, and vice versa".

If we simply take this years outlook as an example. Italy, as we have seen, is unlikely to achieve more than 1% real GDP growth (and this a year of strong global expansion), but the country might just get nominal GDP growth of 4%, since inflation is currently running near to 3%. At the same time Germany may have GDP growth nearer 4%, and inflation around 1% lower than Italy. These kind of inflation differentials just don't make sense, when you consider that it is Germany that is booming, and Italy that is near to falling back into recession. Such differences are symptoms of deep economic rigidities in Italy.

So what if Italy were to have 1% inflation, and 3% real GDP growth? Well, just how plausible is this? Germany, as we have seen, has only been able to get 1.3% annual growth in productivity over the last decade, and it is hard to see Italy doing better, no matter how deep the structural reforms introduced. Indeed, Italy's long term trend growth has been slipping steadily over the last half century, at the rate of about 1% a decade, according to the Italian economist Francesco Daveri:

"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."

Since he wrote this in 2006, and growth over the decade was something like an average of 0.6% I would say that his expectation wasn't a bad guess. What puzzles me at all the people who now "guess" that Italy will be able to put in enough a much higher growth rate over the next decade.

All Together Now: "I Believe In Structural Reforms"

The IMF are expecting real growth of about 1.3% between 2012 and 2015, and the EU forecasts are not substantially different. As average growth rates this seem very optimistic to me, especially given the recent performance.

All efforts seem to be directed towards impelling structural reforms, and this in itself is worrying, since what we seem to have is something more akin to blind faith than to sound empirical economic analysis. The most recent IMF Article IV Report concludes that: “only a bold and comprehensive structural reform program will unleash Italy’s growth potential”. But what is the likelihood of such a bold and comprehensive programme being introduced, and anyway, how much do we really know about Italy's real growth potential at this late day in its demographic history? While echoing the "structural reforms" mantra, the OECD is rather more cautious:

Italy’s economy has passed the deep recession triggered by the global crisis and seems set for a gradual recovery. The strength of this recovery is uncertain: it would be wise to plan for no more than the rather sluggish growth seen in the decade prior to the crisis.

The problem is, like many on Europe's periphery, after a decade of Euro membership the Italian economy is seriously distorted, and badly in need of devaluation, but of course, as elsewhere there is no currency left to devalue, hence some sort of debt restructuring to reduce the burden of interest payments may be the only alternative while we await the jury's verdict as to whether all these structural reforms work or not.

Many, of course, will say that Italy is a lot richer than it seems, since so much economic activity takes places in the informal sector. But this is entirely beside the point, since the informal sector by definition does not pay taxes, and I will believe a promise to reduce the importance of the informal sector when I see the results. In the meantime Italy is, at best, a country which is much richer than it seems where government finances are in danger of spinning off into an unsustainable debt spiral.

As Standard & Poor's put it in the statement accompanying their decision last week to put Italian Sovereign Debt on rating watch negative: "In our view Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering. Potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy's prospects for reducing its general government debt have diminished."

Just What Is The Real Level Of Government Debt In Europe?

2010-02-14T14:35:00.000+01:00

“If you don’t fully understand an instrument, don’t buy it.”

To the above advice from Emilio Botín, Executive Chairman of Spain’s Grupo Santander, I would simply add one small rider: Don’t sell it either, especially if you are a national government trying to structure your country’s debt.

In a fascinating article in today's New York Times, journalists Louise Story, Landon Thomas and Nelson Schwartz begin to recount the mirky story of just how the major US investment banks have been able to earn considerable sums of money effectively helping European governments to disguise their growing mountain of public debt.

Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

In fact, concerns about what it is exactly Goldman Sachs have been up to in Greece are not new, and the Financial Times have been pusuing this story for some time, in particular in connection with the investment bank's ill fated attempt to persuade the Chinese to buy Greek government debt (and here, and here). Nor is the fact that the Greek government resorted to sophistocated financial instruments to cover its tracks exactly breaking news, since I (among others) have been writing about this topic since the middle of January - Does Anyone Really Know The Size Of The Greek 2009 Deficit? - following the arrival in my inbox of a leaked copy of the report the Greek Finance Minister sent to the EU Commission detailing the issues.

What is new in today's report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since "Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere". I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.

So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset "sales", often of public buildings and the like. Following advice paid for from the best of investment banks many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain "hecha la ley, hecha la trampa" (or in English, when you close one loophole you open another). According to the NYT authors:

"As recently as 2008, Eurostat.... reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”"

So just what is all the fuss about. Well, in plain and simple terms it is about an accounting item known as "receivables". Now, according to the Wikipedia entry:

"Accounts receivable (A/R) is one of a series of accounting transactions dealing with the billing of a customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms."

However, as we can learn from another Wikpedia entry, often the use of "accounts receivable" constitutes a form of factoring, and this is where the problems Eurostat are concerned about actually start:

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

But how does all this work in practice? Well, the World Wide Web is a wonderful thing, since you have so much information near to hand, at just the twitch of a fingertip. Here is a useful description of what are known as PPI/PFI schemes, from UK building contractor John Laing:

A Public Private Partnership (PPP) is an umbrella term for Government schemes involving the private business sector in public sector projects.

The Private Finance Initiative (PFI) is a form of PPP developed by the Government in which the public and private sectors join to design, build or refurbish, finance and operate (DBFO) new or improved facilities and services to the general public. Under the most common form of PFI, a private sector provider like John Laing will, through a Special Purpose Company (SPC), hold a DBFO contract for facilities such as hospitals, schools, and roads according to specifications provided by public sector departments. Over a typical period of 25-30 years, the private sector provider is paid an agreed monthly (or unitary) fee by the relevant public body (such as a Local Council or a Health Trust) for the use of the asset(s), which at that time is owned by the PFI provider. This and other income enables the repayment of the senior debt over the concession length. (Senior debt is the major source of funding, typically 90% of the required capital, provided by banks or bond finance). Asset ownership usually returns to the public body at the end of the concession. In this manner, improvements to public services can be made without upfront public sector funds; and while under contract, the risks associated with such huge capital commitments are shared between parties, allocated appropriately to those best able to manage each one.

And for those still in the dark, Wikipedia just one more time comes to the rescue:

The private finance initiative (PFI) is a method to provide financial support for "public-private partnerships" (PPPs) between the public and private sectors. Developed initially by the Australian and United Kingdom governments, PFI has now also been adopted (under various guises) in Canada, the Czech Republic, Finland, France, India, Ireland, Israel, Japan, Malaysia, the Netherlands, Norway, Portugal, Singapore, and the United States (amongst others) as part of a wider program for privatization and deregulation driven by corporations, national governments, and international bodies such as the World Trade Organization, International Monetary Fund, and World Bank.

PFI contracts are currently off-balance-sheet, meaning that they do not show up as part of the national debt as measured by government statistics such as the Public Sector Borrowing Requirement (PSBR). The technical reason for this is that the government authority taking out the PFI contract pays a single charge (the 'Unitary Charge') for both the initial capital spend and the on-going maintenance and operation costs. This means that the entire contract is classed as revenue spending rather than capital spending. As a result neither the capital spend nor the long-term revenue obligation appears on the government's balance sheet. Were the total PFI liability to be shown on the UK balance sheet it would greatly increase the UK national debt.

And here are two more examples of what is involved which were brought to light by a quick Google. First of all, the case of Italian health payments. Now according to analysts Patrizio Messina and Alessia Denaro, in this report I found online from Financial Consultants Orrick:

In the last years many structured finance transactions (either securitisation transactions or asset finance transactions) have been structured in relation to the so called healthcare receivables.The reasons are several. On one side, the providers of healthcare goods and services usually are not paid in time by the relevant healthcare authorities and therefore, in order to gain liquidity, usually assign their receivables toward the healthcare authorities. On the other side, due to the recent legislation that provides for very high interest rates on late payments, the debtors as well as banks and other investors have had the same and opposite interest on carrying out different kind of transactions. In this brief article we will analyse, after a quick description of the Italian healthcare system, some of the different structures that have been used in relation to transactions concerning healthcare receivables and, in particular, we will focus on transactions concerning the so called “raw receivables”, which are lately increasing in the Italian market practice, by analysing the legal means through which it is possible to ascertain/recover such receivables.

This system thus has two advantages (apart from the fact that it effectively hides debt). In the first place the healthcare providers gain liquidity in order to continue to run hospitals, pay doctors, etc, while those who effectively intermediate the transaction earn very high interest rates for their efforts, interest payments which have to be deducted from next years health care provision, and so on.

As the Orrick report points out, Italy’s national healthcare service (servizio sanitarionazionale, “nhs”) is regulated by the legislative decree of December 30, 1992, no. 502 (“decree 502/92”).The reform introduced by decree 502/92, as amended from time to time, provides for a three-tier system for the healthcare service, as outlined below: State level The central government provides a national legislation limited to very general features of the NHS and decides the funds to be allocated to the single regions according to specific criteria (density of population, etc.) for the NHS.

As the Orrick analysts note: "the Healthcare Authorities usually pay the relevant Providers with a certain delay".

Usually, when healthcare funds are allocated, in the national provisional budget, the central government underestimates the amount of healthcare expenditure. Since the central government does not provide regions with enough funds, regions are not able to provide enough funds to Healthcare Authorities, and payments to the Providers are delayed. Since the Providers need liquidity, they usually assign their receivables toward the Healthcare Authorities. To deal with all the above issues, Italian market practice has been developing an alternative system of financing through securitisation and asset finance transactions of Healthcare Receivables.

As the analysts finally conclude:

Despite of the risks concerning the judicial proceedings, Italian market players are still very interested on carrying on securitisation transaction on this kind of asset, principally because Legislative Decree no. 231/02 provides for very high interest rates on late payments (equal to the interest rate applied by ECB plus 7%) - my emphasis

Another technique Eurostat have identified as a means of concealing debt relates to the recording of military equipment expenditure, as described in this report I found dating from 2006. At the time Eurostat were worried about the growing provision of military equipment under leasing agreements. Basically they decided that such provision was debt accumulable.

Eurostat has decided that leases of military equipment organised by the private sector should be considered as financial leases, and not as operating leases. This supposes recording an acquisition of equipment by the government and the incurrence of a government liability to the lessor. Thus there is an impact on government deficit and debt at the time that the equipment is put at the disposal of the military authorities, and not at the time of payments on the lease. Those payments are then assimilated as debt servicing, with a part recorded as interest and the remainder as a financial transaction.

However, a loophole was found in the case of long term equipment purchases:

Military equipment contracts often involve the gradual delivery over many years of a number of the same or similar pieces of equipment, such as aircraft or armoured vehicles, or including significant service components, such as training. Moreover, in the case of complex systems, it is frequently the case that some completion tasks need to be performed for the equipment to be operational at full potential capacity. Some military programmes are based on the combination of several kinds of equipment that may be completed in different periods, so that the expenditure may be spread over several fiscal years before the system, globally considered, becomes fully operational.

In cases of long-term contracts where deliveries of identical items are staged over a long period of time, or where payments cover the provision of both goods and services, government expenditure should be recorded at the time of the actual delivery of each independent part of the equipment, or of the provision of service.

Payment for such items are only to be classifed as debt at the time of registering the actual delivery, which may explain why, if my information is correct, the Greek military as of last December were still officially "testing" two submarines which had been provided by German contractors, since final delivery had still to be formally registered, and the debt accounted.

A lot of information about the kind of things which were going on before the 2006 rule change can be found in this online presentation from Europlace Financial Forum. Here are some examples of private/public sector cooperation in Italy.

And here's a chart showing a list of advantages and possible applications:

Now, at the end of the day, you may ask "what is wrong with all of this"? Well quite simply, like Residential Mortgage Backed Securities these are instruments that work while they work, and cause a lot of additional headaches when they don't. I can think of three reasons why debt aquired in this way in the past may now be problematic.

a) they assume a certain level of headline GDP growth to furnish revenue growth to the public agencies committed to making the payments. Following the crisis these previous levels of assumed growth are now unlikely to be realised.
b) they assume growing workforces and working age populations, but both these, as we know, are now likely to start declining in many European countries.
c) they assume unchanging dependency ratios between active and dependent populations, but these assumptions, as we also already know, are no longer valid, as our population pyramids steadily invert.

Given all this, a very real danger exists that what were previously considered as obscure securitisation instruments, so obscure that few politicians really understood their implications, and few citizens actually knew of their existence, can suddenly find themselves converted into little better than a glorified Ponzi scheme.

And if you want one very concrete example of how unsustainable debt accumulation can lead to problems, you could try reading this report in the Spanish newspaper La Verdad (Spanish, but Google translate if you are interested), where they recount the problems being faced by many Spanish local authorities who are now running out of money, in this case it the village of San Javier they have until the 24 February to pay a debt of 350,000 euros, or the electricity will simply be cut off! The article also details how many other municipalities are having increasing difficulty in paying their employees. And this is just in one region (Murcia), but the problem is much more general, as Spain's heavily overindebted local authorities and autonomous communities steadily grind to a halt.

The Italian Economy Contracts Again in Q4 2009

2010-02-12T12:56:00.010+01:00

Well, it isn't only my German economy Q4 call, or my Japanese economy one which look OK right now, this Italian one also now seems very much to the point.

In fact, as I suspected it might, the Italian economy went back into contraction mode in the last three months of 2009.

Italy's economy shrank by 0.2 percent in the fourth quarter of 2009, inverting the growth it had experienced in the third quarter, according to national statistics agency Istat in a preliminary forecast. Italian gross domestic product (GDP) shrank by 0.2 percent compared to the third quarter when adjusted for seasonal variations.

Italy's GDP shrank by 4.9 percent in the 2009, a result which was slightly worse than than the 4.8 percent contraction the Italian government had predicted. The fourth quarter figure was worse than had been expected by economists who had forecast a 0.1 percent growth, according to a consensus polled by Dow Jones Newswires. Istat blamed the decrease on a fall in the value added by Italian industry. In January, the Italian government revised its economic growth forecast for 2010 upward - from 0.7 percent to 1.1 percent.

Perhaps the best way of putting the seriousness of Italy's situation in some kind of perspective is to say that GDP levels are still below those of early 2003. My opinion is that even in the best of cases Italian trend GDP growth is now below 0.5% per annum, and indeed it may well be approaching zero.

The Italian Lion Sleeps Tonight, And Yet Awhile..........

2010-01-17T06:33:00.005+01:00

“If we look at public-sector debt and interest payments, Greece isn’t doing particularly worse than Italy,” Peter Westaway,Chief Economist Europe at Nomura International

To everyone's relief, Italy's economy returned to growth in the third quarter of 2009, following five consecutive quarters of contraction. But that doesn't make the future look or feel any more secure than the recent past, and while an immediate return to a sharp recession isn't likely, it still isn't clear whether the Q3 performance was repeated over the last three months of last year, or whether output remained more or less flat. This does seem to be a more or less a touch and go call, and while the final result will hardly be a shocker one way or the other, my feeling is that we are looking at growth in the region of -0%. That is to say, slight contraction is marginally more likely than slight expansion. So Italy's economy is more or less dormant, but it's debt to GDP ratio is not, and is moving steadily upwards (see the last section of this post), so the lion sleeps tonight, and goes on sleeping, but what will happen tomorrow when she, or rather the financial markets, finally wake up, and discover seems evident, at least to me and Peter Westaway, that in the longer run Italy's sovereign debt problem is every bit a large as the Greek one, although given that most of the debt is in fact held by Italians, the threat to the good functioning of the eurosystem may well be proportionately less.

A "Weak" Recovery

If the most recent past is still clouded in uncertainty, what is a little less in doubt is the sort of rebound we might expect from the Italian economy, since any bounceback will surely be extremely muted to say the least. The Italian economy has been loosing steam for decades now, and only grew by something less than 0.5% per annum over the last - boom - decade. With the working age population declining and ageing, the outlook for the next decade is hardly improved.

My best-guess estimate is that the Italian economy contracted by something like 4.8% in 2009 (just a little less than the 5% German contraction), following a 1% drop in output in 2008. Consenus opinion is mildly optimistic for the year to come, but expectations are modest with the Bank of Italy arguing that what is still the euro region’s third-biggest economy will experience a “weak recovery” this year and a 0.7 percent expansion in 2011. Of course, as with forecasting the weather, the further into the future you move, the greater the level of uncertainty which is attached to any growth estimate, and in current global conditions this is even more the case. The Italian central bank forecast compares with a November projection from the Organization for Economic Cooperation and Development of 1.1 percent growth this year and 1.5 percent in 2011, while the IMF projects 0.25% growth for 2010 and 0.75% for 2011, and the EU Commission currently project 0.7% for this year and 1.4% for 2011.

Certainly all parties project that internal consumption will remain weak, and what growth they are expecting should be driven by external demand, which, of course, is itself subject to considerable uncertainty as government stimulus after government stimulus is steadily withdrawn. Almost all EU economies are now looking to live from surplus demand in other countries, and like the British working classes in the nineteenth century they can't all surely hope to live from "taking-in each others washing".

More than talking about growth, what we are really talking about is getting back to where we were, since if we look at the level of Italian GDP, it is clear that there has been a sharp drop in output since the start of 2008, and at current rates of growth it will be many years before we get back up to 2007 levels.

Mario Draghi, Governor of the Bank of Italy suggested at the end of last year that it would take four years for the Italian economy to return to its 2007 size. If the recovery is slower than anticipated these four years could easily turn into five or six with fairly serious implications for the Italian sovereign debt dynamic. Indeed, there already appear to be more downside risks emerging than the above forecasts contemplated and I'm inclined to agree with that doyen of Italian economy bank analysts - Unicredit's Marco Valli - when he argues for a likely upper limit to growth this year at around 0.5%, with plenty of scope for it to come in even lower.

Touch and Go In Q4

" We doubt that the pace of growth seen in the third quarter will be maintained in the fourth one: given the weak momentum with which industrial production closed the third quarter (-5.3% monthly in September after +5.8% in August), a substantial deceleration in industrial activity and GDP is likely in the final quarter. However, given that manufacturing surveys keep pointing north, car registrations remain firm and there are increasing signs that services activity is starting to re-gain some traction, we have penciled in flat GDP for the fourth quarter"
Unicredit's Italy Economist, Marco Valli, 23 November 2009

In line with most analyst expectation expectations, the Italian economy expanded by 0.6% between the second and third quarters of 2009, an improvement which was largely driven by a 4.3% quarter on quarter (qoq) rise in industrial output. GDP also benefited from a rebound in exports (+2.5% qoq) and machinery/equipment investment (+4.2%), some growth in private consumption (+0.4%, on strong car registrations) and a moderately positive contribution from inventories (+0.1pp). The evident weakness was construction investment, which continued to fall sharply (-2.1%).

Industrial production has been steadily losing momentum in the fourth quarter, and was up only 0.2% in November, on the back of a revised 0.7% increase in October. These rises follow a sharp 4.9% drop in September which means, assuming the upward December output rise is close to that indicated in the last PMI, industrial production in the last three months will be more or less flat in the final quarter when compared with the third, and could even be slightly down.

On the other hand, Italian consumer activity - normally the weak spot in Italian GDP - does seem to have recovered rather during the quarter. Consumer confidence has imporved considerably of late.

And while retail sales have long since stopped their upward trend ...

the retail PMI showed growth in both November and December following 32 consecutive months of decline.

Also services activity has been stronger, with the services PMI registering growth during the fourth the quarter for the first time in many months.

In fact private consumption has been looking up in the last two quarters, and this trend may continue.

However, at some point there will be a deceleration in momentum, since consumption will undoubtedly be negatively affected by the expiration of the car scrapping premium. As Marco Valli puts it: "the extent of the correction in durable goods spending crucially depends on whether the government decides to quit the premium outright (which we regard as unlikely) or opts for a gradual phasing out of the incentive scheme (more likely)". It is worth bearing in mind, however, that even if the current premium scheme were to be fully confirmed for the whole of 2010, the effect on car registrations would be much more restrained than in 2009, due to the fact that most of the earlier pent-up demand has already been met.

Is Italy Export Dependent?

Even if this seems strange to many people, the Italian economy is, in fact, highly export-driven. In this sense Italy is heavily reliant upon the recovery of German demand, and it just thios demand which now seems to be faltering. In Q1 2009, German imports fell 5.4% over the previous quarter, after dropping in Q4 2008, driving Italy's economy further and further down.

Exports amounted to some 28.8% of Italian GDP in 2008. In the third quarter of last year Italian exports grew by 2.5% on the quarter following a 2.5% drop in the previous one, while imports were only up 1.5% following a 2.5% drop in the second quarter. Thus the trade factor was positive for GDP growth. This situation seems set to change in the last quarter. Seasonally adjusted October exports were down, while imports fell less than exports, and if this trend is continued in November and December net trade will in fact be a drag on GDP. To my insufficiently well trained eyes it looks very much like the German car stimulus gave a big boost to Italian industry in August, and that this effect is now waning, even if the domestic Italian stimulus counterbalances to some extent.

Fixed Capital Investment Stimulated By Tax Incentives

Capital spending decisions look little better. Spending on machinery and equipment was up 4.2% quarter over quarter in Q3, but was still down 16.1% on the year, and the relatively strong recent performance is partly due to a tax incentive provided by the Italian government.

Again, Marco Valli points out that investment decisions are likely to remain conservative next year, since levels of corporate indebtedness are still high in an environment where profitability is notably weak. Moreover, extremely depressed capacity utilization rates will unavoidably put a ceiling on business investment. However, Valli suggests that firms will undoubtedly continue to take advantage of the tax bonus on machinery investment to replace old machinery during the first half of the year. When the bonus finally expires in July 2010, it is likely there will be a sizeable capex correction. As a result Unicredit expect machinery investment to drop 0.9% in 2010 following a likely -16% in 2009.

Official Figures Underestimate Unemployment

In November 2009 the Italian unemployment rate reached 8.3% in Novemember, as compared to 7.0% a year earlier. The European Commission expects the annual unemployment rate to rise to 7.8%in 2009 and 8.7% in 2010. The OECD's November 2009 economic outlook also expects Italian joblessness to peak in 2011 at 8.7%.

But the EU harmonised method of calculating unemployemnt rather underestimates the situation in the Italian case, and Italy’s real unemployment rate is significantly higher (around 10.7% according to Bloomberg calculations) once you add-in those workers paid by a fund known as cassa integrazione, or CIG. The CIG pays laid off employees about 80 percent of their salaries for up to two years.

Again Bloomberg calculate that use made by Italian companies’ of the CIG fund quadrupled to almost 1.5 billion euros in 2009 from 365 million euros in 2008. The official cost of the CIG in 2009 will be published in the annual report of INPS (the Rome-based agency that handles the welfare payments) later this year. Under Italian law, businesses suffering from a downturn can lay off permanent employees for as long as two years and take them back when conditions improve. In fact CIG aid can be extended to five years if the government decides that circumstances are “exceptional.”

Difficult Years Ahead If Italy Wants To Consolidate Its Fiscal Position

The overnment's response to the present crisis has been - at least formally - rather moderate due to the need to avoid a substantial deterioration in public finances, given the very high level of already existing government debt in a context of increased global risk aversion. Evidently the Italian government didn't want to draw attention to itself in the way the Greek one has. As a result measures taken to support low-income groups and key industrial sectors have been largely financed by reallocating existing funds, and this is even largely true of the additional stimulus package of 4.5 billion euros, in an effort to "intensify actions against the crisis," according to Minister of the Interior Claudio Scajola in a statement at the time.

However, even given this evident restraint, the EU Commission sill forecast that the government deficit probably widened to 5.3% of GDP in 2009 (from 2.7% in 2008) and remain at around that level in both 2010 and 2011. In comparison to other EU country deficits this is not big beer, but it does need to be situated within the context of the long history of public indebtedness in Italy.

Primary expenditure looks likely to have risen by more than 4.5% in 2009, significantly faster than planned in the stability programme update submitted to the EU Commission in February 2009. In particular, public sector wage growth is continuing to outpace inflation. In addition, government financed consumption via social transfers grew considerably in 2009 due to a combination of pensions being indexed to the previous-year's inflation, one-off transfers to poor households and the extended coverage of the wage supplementation fund. Capital spending also rose by an estimated 13%, as a result of recovery measures that bring forward some previously agreed investment plans. The only significant item expected to decrease is interest expenditure, which is benefitting from historically low short-term interest rates.

While the strength of the 2009 downturn understandably derailed the three-year budgetary consolidation plan adopted in summer 2008, a marked slowdown in expenditure dynamics is likely in 2010 and 2011, as the government attempts a return to the planned consolidation path. Capital expenditure is set to decrease in both years, while modest increases are projected for current primary expenditure. Interest expenditure is also expected to rise, due to monetary policy decisions at the ECB and the expanding size of the debt itself.

The EU Commission estimate that the gross government debt-to-GDP ratio climbed by almost 9 percentage points in 2009, to around 114.5%, and forecast that it will continue rising to around 118% in 2011. The 2009 increase is overwhelmingly due to the sharp fall in nominal GDP. Looking forward, the EU Commission emphasise that ongoing interaction between high debt-service requirements and Italy's low potential GDP growth rate underlines the importance of raising the primary balance so as to put the very high debt ratio on a declining path once again.

In this context, one of the concerns about Italy's government debt trajectory is the extent of recourse to one-off and make-and-mend measures to keep the state finances afloat. One good example of such a measure are the tax amnesties, a technique which Italian Finance Minister Guilgio Tremonti has had considerable experience with, since in both 2001 and 2003, as part of an earlier Berlusconi government, he enacted similar measures that brought some 20 billion euros back to Italy, with a further 15 billion euros being declared by Italian clients of Lugano banks, though it remained in Switzerland. But the yield the first time round has been dwarfed by the rich harvest this time. Mr. Tremonti recently announced that Italians had declared 95 billion euros in assets under the plan, with some 98% of the money being brought into Italy from offshore sources. The harvest should have added something like 5 billion euros to 2009 Italian tax revenue, and although the plan formally expired on December 15, a further ammnesty period is not ruled out.

In fact the Italian Finance Minister has often come under attack from those who want to see the government taking more decisive action against the economic crisis, but his insistence on fiscal prudence appears to have been justified, given the difficulties currently facing Greece. For once an Italian government can be congratulated for its prudence, and the risk premium on Italian government bond yields was just overcompared with benchmark German bunds is running somewhere around 80 basis points as compared with Greece, where the spread is now over 250 basis points.

Resources are also being acquired from the Trattamento di fine rapporto (TFR), a fund containing contributions paid by employers for employees' severance pay when they retire, leave their jobs or are made redundant. Although there is little doubt that the government will eventually reimburse the money, it is likely that it will have to resort to increased taxation or cuts in expenditure to do so.

So the issue is, that far from using the crisis as a justification for implementing the much needed deep-seated reform, it has instead and once more been used as an excuse for postponing it. I leave you with the words of The Italian economist Francesco Davieri, writing last June in the economics portal VOX EU:

If Italy’s government does not push reform more aggressively – issues like pension reform, the schooling and university system, and the labour market – the most likely scenario is that the Italian economy will return to its usual...[lacklustre]....annual growth after the crisis. This is why postponing reforms in today’s Italy is like consuming a luxury good when you are close to starvation. Today’s Italy just can’t afford it, if it wants to resume faster long-run growth.

Facebook Links

2009-06-20T12:29:00.001+02:00

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't fit any mould, and Iam hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

Italian GDP Falls An Annualised 9.6% In The First Three Months Of 2009

2009-04-27T19:09:00.018+02:00

Italy's recession deepened at the start of 2009, with first-quarter gross domestic product falling to its worst level since at least 1980, confirming the impression that Europe's fourth-largest economy is now headed for its worst downturn since World War II. Preliminary data from the national statistics office (Istat) show that Italian GDP fell 2.4% in the first quarter when compared with the last quarter of 2008. This follows a downwardly revised 2.1% contraction in the fourth quarter of last year. Annualised this means a 9.6% contraction rate during the three months, which is very high indeed.

Year on year GDP fell by 5.9%, which was also the sharpest drop since Istat's most recent data series starts in 1980 - or for at lest 29 years. The contraction was even worse than analysts were predicting, with the consensus having been for a 1.8% drop on the quarter and a 5% one on the year.

According to ISTAT, even if GDP stays flat for the remaining three quarters of the year, 2009 GDP will contract by 4.6%. According to my rough calculations, Italy's GDP was on about the same level this quarter as it was in the first three months of 2005, and from here we are travelling back in time.

But GDP is not remaining flat, even if the pace of contraction seems to have slowed in the present quarter.

PMIs Show Continuing Contraction - Although The Rate Eased In April

Italy continued to register the steepest overall fall in retail sales in the Eurozone in April according to the Bloomberg Retail PMI. The month-on-month sales index did however rise from 41.9 in March to 46.8 giving the slowest rate of decline since October 2007. Retail sales have now fallen for 26 months consecutively according to survey data.

Manufacturing Output Falls

Italy's manufacturing business shrank at its slowest rate for six months in April, with the latest Markit/ADACI survey producing a headline PMI reading of 37.2 - significantly above March's record low of 34.6 and beating the consensus forecast of 36.5.

In addition other recent data suggest that the lowest point may have been past with business confidence improving in April (following 10 consecutive monthly falls), and consumer morale hitting its highest level in 16 months. However Markit reported that about 40 percent of companies in the survey reported new order levels continued to fall during the month, even though at the slowest rate of decline in seven months. Output fell at its slowest rate since October, with the sub-index jumping to 35.9 in April from 32.8 in March. Overseas orders, even though they fell less sharply in April, still clocked up their 14th successive month of decline, with Markit noting that demand was particularly weak from Eastern Europe and Russia.

And job losses in Italy's manufacturing sector showed no signs of letting up and were running at the second fastest rate in almost 12 years of data collection following the record low hit by the employment index in March.

However, saying that the "darkest hour" in this contraction may be over is not the same thing as saying that recovery is anywhere in sight. Italy's manufacturing PMI has now not indicated growth since February 2008 and forecasts generally expect the economy to contract by around four percent this year, making for two straight years of continuous contraction for the first time since World War Two. Indeed, the Organisation for Economic Cooperation and Development has even already pencilled in a potential further contraction for 2010, which if realised will mean Italy's economy will have been shrinking for an almost unprecedented 3 years continuously.

As Does Services

Italian service sector activity contracted for the 17th consecutive month in April although at the slowest rate for six months. The Markit/ADACI Purchasing Managers' Index rose to 42.0 from 39.1 in March, but still is not that far above the record low of 37.9 recorded in February. Activity has now been stick below the 50 mark that separates growth from contraction since November 2007.

The survey showed new business shrinking for the eighteenth straight month in April, though the rate of decline eased for the second month running, while expectations of business in a year's time rose to an eight-month high. As elsewhere, while optimism is rising Markit did point to record job losses as a likely on consumer spending looking ahead, making hopes of a swift recovery extremely premature. The employment sub-index fell to 44.0 from 44.6, as firms cut jobs at a survey record rate in response to the ongoing loss of business. The survey is thus consistent with other recent indicators that have pointed to an economy still mired in the deep recession that began in spring of last year, but with some grounds for thinking that the lowest point may now have been passed.

Deflationary pressure remained evident with service firms cutting their prices for the seventh month running and at the fastest rate in the survey's history in response to weak demand, while input prices showed no monthly increase for the first time since the survey began. The Italian government slashed its economic forecasts last week, and now project gross domestic product to fall by 4.2 percent this year following last year's 1.0 percent decline. The International Monetary Fund is more pessimistic, forecasting a 4.4 percent fall this year and a further drop of 0.4 percent in 2010. Italy thus now possibly faces three years of economic contraction one after the other although previously the country had not posted two consecutive years of falling GDP in its entire post-war history.

Business and Consumer Confidence Rebound Slightly

Italian consumer confidence rebounded slightly in April and reached its highest level since December 2007 as the lure of slowing inflation seemed to offset concerns about rising unemployment. The Isae Institute’s consumer confidence index rose to 104.9 from 99.8 in March.

Italian business confidence also rose as companies saw signs of an increase in orders of goods and services following the sighting of green sprouts everywhere except under our noses. The Isae Institute’s business confidence index climbed to 64.2 from a revised 60.9 in March.

Industrial Output

Industrial output simply declined and declines, and fell in March for an 11th consecutive month. Output dropped a seasonally adjusted 4.6 percent from February, when it fell a revised 4.6 percent, according to data from the national statistics office. From a year earlier, adjusted production fell 23.8 percent. Fiat has laid off about half of its 78,000 national workforce in using temporary state-subsidized programs. Sales of their cars fell 16 percent in Italy in the first quarter, according to data from the trade association ANFIA.

Exports Remain Very Weak

Italy's trade deficit increased dramatically to 837 million euros in February, almost double the 449 million euros recorded in the same month in 2008. Istat said a fall in demand was recorded in all sectors, but the automobile sector was particularly hard hit with a fall in exports of 46 percent. Trade in the chemical sector was down 29.5 percent, electrical goods were down 27.3 percent and exports of other manufactured goods fell by 22.7 percent.

Imports were down by 25.3 percent at 24.3 billion euros while exports were down by 23.7 percent at 23.5 billion euros. The results, however, were slightly better than in January, when imports were 23.4 billion euros and exports 19.8 billion euros. This was effectively the worst decline in exports since these statistics were first compiled by ISTAT in 1993.

No End To The Recession In Sight
Italy effectively entered recession in third quarter of 2008, and the economy now looks bound to shrink the most in more than half a century this year. The International Monetary Fund forecast on April 22 that the jobless rate will reach 8.9 percent this year and 10.5 percent in 2010. At the same time, Italian inflation has been slowing and hit a record low of 1.1 % in March, so if the contraction continues the deflation threat is real and present.

According to the latest EU Commission forecast Italy’s gross domestic product will fall this year by 4.4 percent, more than twice the 2 percent it predicted three months ago. This is bound to have a substantial impact on government debt, and the Italian government already accepts that the budget deficit will rise this year and breach the European Union limit of 3 percent of GDP. Government spending climbed 21 percent in the first quarter from a year earlier, while revenue fell 4.8 percent, the Bank of Italy said on May 13. The EU Commission forecast a deficit of 4.5% of GDP this year and 4.8% in 2010. As a result gross government debt is projected to climb from 105.8% of GDP in 2008 to 113% in 2009 and 116.1% in 2010. A grim picture, and no easy solutions.

Italian Industrial Output Continues To Decline In February

2009-04-09T09:46:00.000+02:00

Industrial production in Italy fell for the eighth month in February as the nation’s worst recession in more than 30 years forced companies to cut output. Production in the euro region's third biggest economy dropped a seasonally adjusted 3.5 percent from January, when it fell a revised 1.2 percent. From a year earlier, working day adjusted production fell 21 percent. The monthly decline was more than the 1.5 percent median forecast of 18 economists surveyed by Bloomberg.

And the picture doesn't seem to have improved any in March, since manufacturing activity fell in Italy at its fastest pace on record, with the manufacturing purchasing managers index falling to a record low of 34.6, down from February's 35.0 and suggesting an unprecedented contraction in activity for the sector. Weakness was widespread, Markit said in their report. Staffing levels were cut at a record pace as firms were forced to adapt to falling workloads and declining new orders. Backlogs of work also declined at their sharpest pace in the history of the PMI as falling demand meant firms to were increasingly able to complete outstanding projects.

The Contraction In Italian Services Continues

Italian service sector activity also stayed close to record lows in March, with employment falling the fastest in over 11 years, according to the PMI survey released last Friday. The Markit/ADACI Purchasing Managers' Index, spanning companies from hotels to insurance brokers, edged up to 39.1 after hitting 37.9 in February, its lowest level since the survey began in January 1998.

The headline measure has not been above the 50 mark that separates growth from contraction since November 2007, and the survey showed jobs were shed in March at a record pace. The survey also showed that companies' input costs and the prices they charged customers were falling at the fastest rate since the series began as firms scrambled to offer discounts to attract business.

"Averaged over the quarter, service sector activity fell at the fastest pace since at least 1998," said Andrew Self, economist at Markit Economics. "The slump is in line with a year-on-year contraction of gross domestic product between 2.5 and 3.0 percent. This implies economic output will contract at a sharper pace in the first quarter, on a quarterly basis, than in the last quarter of 2008."

The Organisation for Economic Cooperation and Development forecast last week that Italy's GDP would plunge 4.3 percent this year and fall 0.4 percent in 2010, giving Italy three consecutive years of economic contraction. According to the OECD unemployment will jump to 9.2 percent after rising in 2008 for the first time in a decade to 6.8 percent.

Eurozone Retail Sales Contract For the Tenth Month In Succession

2009-03-30T18:30:00.001+02:00

The Bloomberg Euro-Zone Retail Purchasing Managers' Index - based on a mid-month survey of more than 1,000 executives in the euro area retail sector - rose marginally in March - to 44.1, up from 42.3 in February to 44.1 in March. This was the smallest monthly drop in the value of sales in five months, but it was still a drop, and quite a significant one, since the neutral point between contraction and expansion is 50. Still first quarter retail sales have seen an average monthly decline which is smaller than in the fourth quarter of last year (an effect of all those stimulus programmes), however sales have now fallen for ten consecutive months.

The German Sales Contraction Accelerates

Retail sales in Germany, the zone's largest economy, dropped for a 10th month in March as unemployment rose and manufacturing industry continued to grapple with a slump in export orders. The retail PMI dropped to 44.4 from 45.4 in February.

German households are cutting spending as a deepening economic slump forces companies to eliminate jobs, pushing up unemployment. The fall comes despite the decision of German Chancellor Angela Merkel to spend about 82 billion euros in measures to stimulate growth, including tax breaks and incentives to buy new cars.

“Consumers were generally unwilling to spend, while evidence of shorter working hours at local companies reportedly curtailed their buying power,” Markit said in the statement. “The overall decline may have been greater were it not for government incentives to scrap old motor vehicles, which continued to support sales in the automobile sector.”

The Italian Sales Contraction Enters Its 25th Month

Italian retail sales contracted for a 25th month in March as the country's worst recession in more than 30 years prompts companies to cut jobs, in the process eating away at consumer demand. The index was up slightly at 41.9, from 38.2 in February.

Italy slipped into its fourth recession since 2001 last year, sending the unemployment rate to a two-year high. The government has adopted around 40 billion euros in stimulus measures, but is constrained from spending more due to the high level of prior government debt. As a result the OECD forecast the economy will likely contract by 4.2 percent this year.

French Sales Hold Up A Little Better

France also saw a moderation in the rate of sales decline, with the pace easing from February's record but remaining steep. Month-on-month the index rose from 42.6 to 45.7, rounding off a first quarter that has seen the weakest sales performance in the history of the French survey. French retailers have reported falling sales in five of the past six months.

Italy's Economic Contraction Accelerates

2009-03-22T19:02:00.014+01:00

There is no doubt that Italy's economic situation has worsened considerably during this quarter. Only last week the OECD forecast that Italy's gross domestic product is likely to fall by 4.2 percent in 2009. This follows a statement earlier this month where the OECD said the situation in Italy this year and next was "much worse" than it had previously thought, and that Italy would not come out of its recession until "sometime" in 2010 at the earliest. According to the earlier forecast the OECD expected GDP to fall this year by one percent and then by a further 0.8 percent in 2010.

The Bank of Italy has also changed its forecast, and now suggest that GDP this year will fall by 2.6 percent. In January (the last time they revised their Italy forecast), the IMF forecast a fall of 2.1 percent. This is almost certain to be revised downwards in the April World Economic Outlook forecast review. Only today the Italian employers’ lobby Confindustria cut its forecast for 2009 GDP , saying the economy will contract by 3.5 percent while public debt will climb to 112.5 percent of GDP.

And these forecasts are not drawn like rabbits out of a hat, since evidence of the deterioration in Italy's economic performance is now to be found everywhere, but perhaps nowhere is it clearer than in the most recent exports and industrial output numbers. Italian exports plummeted 26 percent in January from a year ago, the biggest drop since records began in 1991. With the drop in exports leaving the country with a trade deficit of 3.6 billion euros.

Meanwhile Italian industrial output fell for a fifth month as what is now the country's worst recession in more than 30 years forced companies to keep cutting output and jobs. Production dropped a seasonally adjusted 0.2 percent from December, when it fell a revised 3.9 percent. From a year earlier, adjusted production fell 16.7 percent, the biggest decline since records began in January 1991.

As we can see from the revised output index, after remaining pretty much stationary from early 2007, production really started to slump in May 2008, and hasn't looked back since.

Italy's manufacturing PMI fell again in February to 35.0 from January's 36.1, and was only marginally above November's series record low of 34.9.

Italian business confidence fell to a record low in March as concern that the fourth recession in seven years will damp orders more than offset lower oil prices and borrowing costs. The Isae Institute’s business confidence index dropped to 59.8, the lowest since the index was created in 1986, from a revised 63.2 in February.

Italian executives also reported having more problems getting credit in February, when the report showed that 40.2 percent of those surveyed said the credit situation worsened, up from 33.5 percent in January. The new orders sub component also fell, to minus 65 from minus 58 in January, the lowest since 1991. And manufacturers’ expectations for production over the next three months fell to minus 24 from minus 20.

Retail Sales Fall

Italian retail sales contracted for the 24th consecutive month in February as the credit crunch tightened its grip on spending, and consumers put off purchases of cars and home appliances.

Services Decline Confirms Accelerating Contraction

Italian service sector activity sank in February to its weakest level on record, the latest sign of a deepening recession in the euro zone's third largest economy, the latest Markit/ADACI PMI survey and the Index, spanning companies from hotels to insurance brokers, fell to 37.9 from 41.1 in January to hit the lowest level since the survey began in January 1998.

GDP Growth In Long Term Decline

Italian fourth quarter GDP fell a downwardly revised 1.9% from the previous quarter, the largest drop since 1980, compared with a downwardly revised 0.7% contraction in the third quarter of 2008 according to data published by the Italian statistics office Istat last week.

On a year on year basis GDP fell a downwardly revised 2.9%, also the sharpest drop since 1980.

Business investments fell by 6.9% during the quarter, consumer spending fell 0.6%, while exports plummeted 7.4%. As can be seen from the chart below, given the endemic weak state of Italian household consumption, GDP growth tends to follow export growth.

Although, of course, household consumption has now been falling back sharply since early 2007.

2008 data for Italian GDP has now also been published, and again the drop of 1,0% has not been seen since 1975.

Italy's economy will shrink by around 2.6 percent this year, a member of the Bank of Italy's executive board said on Wednesday, cutting the central bank's previous forecast of a 2.0 percent contraction made in January.

Since January, Italian economic data has been consistently bad, with business confidence and purchasing managers' indexes plumbing new record lows. The government pencilled in a forecast of -2.0 percent in its Stability Programme issued in February, but many analysts have cut their forecasts even lower than the BOI. Intesa San Paolo, Italy's largest bank, has a forecast of -2.9 percent.

While Italy’s unemployment rate rose in the fourth quarter to the highest in more than two years as the recession deepened, prompting companies to reduce production and jobs. Joblessness increased to a seasonally adjusted 6.9 percent from 6.7 in the previous quarter, the Rome-based national statistics office said today. The number of unemployed rose to 1.73 million in the third quarter, when 1.69 million people were out of work.

Little Room To Manouevre As The Credit Crunch Tightens

For some time now Italy’s government has been abandoning its optimistic rhetoric and adoptinmg a more sombre assessment of the economy. Giulio Tremonti, the finance minister, recently told a conference that 2009 would be “even more difficult” than last year, with two leading newspapers quoting him as saying Italy faced a “horrible year”.

Tremonti said the government would look next week at providing more to help the growing numbers of unemployed, on top of €8bn it says has already been set aside for extra benefits.

Italian consumer confidence fell for the first time in three months in March, with the Isae Institute’s consumer confidence index dropping to 99.8 from a revised 104 in February.

Growing evidence suggests that the crisis is really hitting the Italian economy in a kind of back-to-front fashion, with the slump in the real economy (and especially the economic crisis in the East of Europe) threatening to drive Italian banks into more and more difficulty. The finance minister is under growing pressure from other cabinet members to increase government spending further, but understandably, Tremonti keeps pointing to Italy’s huge public debt as a major impediment to any serious stimulus plan. So it is simply a question of grin and bear it.

Tremonti admitted at a recent meeting with banks, companies and unions that Italy had seen a greater credit market conditions tightening in recent months than most other eurozone economies. On the other hand he pointed to the fact that Italian banks had shown a “strong interest” in taking up the government-backed bond offer (which only totals €12bn) at the same time as he rejected criticism that the 8.5 per cent interest rate they carry was too high.

Intesa Sanpaolo, which is Italy’s biggest bank by market value, has announced that it will apply for 4 billion euros worth of the bonds after it posted a 1.23 billion-euro fourth-quarter loss on writedowns. This makes Intesa the third Italian lender to take advantage of the country’s bank aid package, following similar decisions by Banco Popolare and UniCredit.

At the same time the credit crunch is evidently producing some sort of housing crisis and the sale of residential properties dropped 15 percent last year, according to OMISE, a government agency that specializes in collecting data on real estate. Property specialists Nomisma forecast house prices will fall 8.5 percent in the second half of 2009, and for a country which has not seen much of a housing boom, this drop is significant. Italian Prime Minister Silvio Berlusconi has announced a housing plan designed to make it easier for property owners to carry out home modernisation. According to Il Sole, Italians will be able to add as much as 20 percent of the current size of their homes without planning formalities. This is obviously rather controversial, and Bank of Italy Governor Mario Draghi was himself pretty non commital in his testimony before a parliamentary commission last week, resticting himself to saying that the “plan could act as a stimulus, although the short-term effect on economic growth is uncertain.”

The Almunia Syllogism

2009-03-22T10:50:00.001+01:00

European Monetary Affairs Commissioner Joaquín Almunia recently, and possibly totally inadvertently, stumbled on a very interesting argument. Here it is:

"Who is crazy enough to leave the euro area? Nobody," Almunia said. "The number of candidates to join the euro area increases. The number of candidates to leave the euro area is zero."

Reductio Ad Absurdum

Now you don't need a PhD in economics to understand what follows, although a little bit of basic logic would help. What we have here could be construed as a kind of syllogism (and from now on let's christen this one "The Almunia Syllogism"). The Almunia Syllogism has the following form:

a) Anyone leaving (or aiding and abetting the departure of someone from) the Eurozone is crazy
b) The EU Commission, The ECB and The National Leaders are not crazy
c) Therefore no one will leave, or be allowed to leave, the eurozone (at least under current conditions)

Q.E.D. We Will Have A United States Of Europe.

Well, ok, I do need to add a lettle lemma here to the effect that the only way to enforce (c) is to build the necessary architecture, and there is room for debate about this, since this lemma is neither proven, nor is it self evident. You also need to accept that there is an excluded middle here, and we do not have a "now either the EU leaders are crazy ot they aren't" fork which we can get diverted down.

As I say, the lemma is not self evident, although my own opinion is that in the weeks and months to come its validity will become extraordinarily clear even to the most reticent among us, but this still needs to be established. The thing about the lemma is that it focuses the debate. Those who do not agree with it need to be able to show how we can have (c) within the present architecture (since here there is a middle to exclude, either we can or we can't). The results coming out from the "we can" camp are not entirely encouraging. For example, ECB Executive Board member Lorenzo Bini Smaghi's recent attempt to argue that Krugman has it wrong, and that (we can manage with what we have) fails stupendously to convince, in my opinion, and especially the extract I reproduce below (which exemplifies precisely the point those who want new achitecture are making).

For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The whole issue is that we need a mechanism to average out the stimulus, is that so hard to understand? Is this obscurantism, or simply stupidity?

A Literary Trope Not A Syllogism

On the other hand, the formal validity of the following "utterance" from Almunia is rather more questionable.

"Don't fear for this moment," he said. "We are equipped intellectually, politically and economically to face this crisis scenario. But by definition these kinds of things should not be explained in public."

The first phrase is an exhortation, one which I would agree with (but not for the same reasons), the second is an assertion whose truth content is, at least, questionable, while the third is an admission, one which would perhaps better not have been made, or a piece of advice, which the unfortunate Otto Bernhardt seems never to have received.

A senior German lawmaker said euro zone states stood ready to come to the aid of financially fragile members of the currency bloc, sparking furious denials from European leaders that a specific rescue plan existed. Otto Bernhardt, a leading lawmaker in Angela Merkel's Christian Democrats (CDU), told Reuters in an interview late on Thursday: "There is a plan."

and then Bloomberg let us know a bit more about the details of the plan.

The German Finance Ministry has no knowledge of a rescue fund organized by the European Central Bank for troubled euro-region members such as Ireland and Greece, spokeswoman Jeanette Schwamberger said.

Otto Bernhardt, finance spokesman for Chancellor Angela Merkel’s Christian Democratic Union, said in an interview with Reuters today that the ECB has a fund at its disposal to help troubled countries and can make money available at 24 hours’ notice.

Here We Go Time Gets Near With Unicredit

2009-03-18T15:17:00.000+01:00

I have been warning on the parlous position of Italy's Unicredit for some time now (see this initial EU Bonds post, or the earlier history of the Unicredit problem, here, here, here, here, here). Well, today the story took another turn for the worse.

It all started yesterday, when Bloomberg came in with a report about Unicredit's eastern exposure, outlining how a decade long expanison, which saw more than $65 billion of acquisitions in operations stretching from Poland to Kazakhstan is now alarming analysts who forecast that loan defaults in eastern Europe, where the bank focused its growth, are set to balloon. Unicredit's stock is down 76 percent in the past 12 months, the second-biggest decline among Italian banks.

“Eastern Europe is the new bogeyman,” said Massimiliano Romano, an analyst at Concentric Italy in Milan. “UniCredit has subsidiaries in 17 different countries there. We used to see that as diversification, now we see it as a risk.”

Then came the news, again yesterday, that the bank had suffered a 57 percent decline in fourth-quarter profit. Finally, this morning, the bank informed us that they are planning to ask for as much as 4 billion euros in government aid. In fact the profit results were not as bad as some analysts had been forecasting, but then these results are for 2008, which, as the company said in its statement, was still a “very good year” in eastern Europe. 2009 looks set to be quite a lot worse, and 2010? As Unicredit CEO Alessandro Profumo said, the bank is "monitoring countries including Ukraine very closely".

In fact the bank is going to apply for aid in both Austria and Italy, and this is not surprising since according to a statement from the Bank of Italy earlier this week, Italy's national debt climbed to 105.8 percent of gross domestic product at the end of last year, up from 103.5 in December 2007. So the credit rating agencies' patience is already being badly strained, even if the quality of their mercy might not be.

Oh, and just to cap it all, and a very bad day for Unicredit, HVB Group, their German banking unit, announced this morning that they had a loss of 671 million euros last year because of writedowns on investments and higher provisions for risky loans. HVB’s trading results were “severely affected by the extreme market turmoil which intensified in the fourth quarter of 2008,” according to the company statement.

Basically, this is that well known proverbial situation, where Europe's leaders twiddle their thumbs, while Rome, almost literally, burns.

Eurozone Inflation Expectations Fall As The Output Gap Rises

2009-03-03T09:32:00.000+01:00

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.

In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.

The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).

And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

2009-03-02T13:52:00.000+01:00

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.

Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).

Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.

Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.

Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.

and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.

So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).

REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.

Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.

Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?

Business Confidence and Retail Sales Fall and Fall

2009-02-26T16:44:00.005+01:00

Italian business confidence fell to a record low in February as concern that the fourth recession in seven years will damp orders more than offset lower oil prices and borrowing costs. The Isae Institute’s business confidence index dropped to 63.2, the lowest since the index was created in 1986, from a revised 65.4 in January.

Italian executives also reported having more problems getting credit in February. The report showed that 40.2 percent of those surveyed said the credit situation worsened, up from 33.5 percent in January. The new orders sub component also fell, to minus 65 from minus 58 in January, the lowest since 1991. And manufacturers’ expectations for production over the next three months fell to minus 24 from minus 20.

Retail Sales Fall

Italian retail sales contracted for the 24th consecutive month in February as the credit crunch tightened its grip on spending, and consumers put off purchases of cars and home appliances.

Italy's entered its fourth recession in seven years in the third quarter of 2008. The Italian government now forecasts the economy will contract 2 percent this year, the second consecutive year of contraction, and even this seems optimistic at this point. The government has announced an 80 billion-euro stimulus plan and 2 billion euros in incentives for the purchase of cars and home appliances., but in general the country is too indebted to be able to do anything very ambitious.

So Italy waits, in the hope that help may come from Brussels, where the 27 members of the EU will meet on Sunday - lead it seems by Angela Merkel - to decide what to do next.

And I hope you are "readying up" that rescue plan Angela, since the difference between German and Italian benchmark bond yields widened to the most in nearly 12 years today as Italy sold 10 billion euros ($12.8 billion) of government securities.

The spread between the 10-year note yields increased as much as four basis points to 161 basis points today, the widest since May 1997, based on generic Bloomberg prices. It was at 155 basis points as of 12:05 p.m. in London. The average in the past 10 years is 31 basis points.

Germany or the International Monetary Fund may be forced to rescue members of the euro bloc that struggle to refinance debt, former Bundesbank President Karl Otto Poehl said today.

“The first will certainly be a small country, so that can be managed by the bigger countries or the IMF,” he said in an interview with Sky News. “There are countries in Europe which are considering the possibility to leave the eurozone. But this is practically not possible. It would be very expensive.”

Creative Accounting and Italy's Growing Unemployment Problem

2009-02-26T16:26:00.003+01:00

It isn't only the bank bailout programme which is suffering in Italy due to lack of sovereign borrowing capacity. (See here for the full background on Unicredit and EU Bonds). I couldn't help noticing this piece in Bloomberg earlier in the week.

Italian Labor Minister Maurizio Sacconi said the government can’t provide unlimited unemployment benefits, La Stampa reported. The government is concerned about unemployment and has freed up about 8 billion euros ($10.3 billion) in regional aid that local entities can tap into, Sacconi told La Stampa in an interview. Still, “we cannot leave the taps running,” Sacconi was also cited as saying.

So as the recession deepens, and layoffs spread, the Italian government is obviously going to have problems keeping people afloat. Which lead me to think, maybe there are two ways to do this, the regular, and the irregular one. And maybe Italy is the ideal place for the application of rather more "unconventional tools" in fighting the crisis, especially since money for the conventional ones is beginning to run scarce.

More Than One Way To Peel An Onion (with and without tears)

First the regular way. Well, as Deutshe Bank reseracher Frank Zipfel points out in this research report, Germany’s economic stimulus packages I and II contain important funding provisions for short-time work, especially to help avert redundancies.

And as can be seen in the graph which Zipfel prepares (see below) recent data show the extent to which these measures are important in keeping unemployment down in Germany. Since the end of November 2008, the number of applications (by both individuals and companies) for funding for short-time work resulting from the economic downturn has soared, affecting above all the mechanical engineering, metal processing and car-making sectors. Even though the number of filings does not reveal how many people are actually in short-time work, the measure does offer a useful indication of how companies are using the measures. In particular the data reveal that nearly 300,000 endangered jobs will not be lost, at least for the time being.

Zipfel explains how the system works:

Germany’s federal agency for employment (BA) will provide funding for short-time work based on business cycle or economic reasons under Section 170 of the Social Security Code (SGB III) if certain conditions are met (among other things, at least one-third of a company's staff must be affected by loan cuts of at least 10% of their monthly gross pay). If this is the case, the amount paid by the BA for each eligible employee is based on 60% (or 67% for employees with children) of the flat-rate calculation of the missing net pay. Employers continue to pay their employees but will be reimbursed by the BA. If, for instance, the hours worked in a company are reduced by half, the employee will receive only half of his/her normal pay. The BA will then pay the employee 60% of the other half of his/her wage or salary. Thanks to substantially reduced wage costs, companies can usually manage without lay-offs, which benefits both sides: employees can keep their jobs and the company its experienced staff. The reduction of working hours and disbursement of funding for short-time work are tied to certain legal provisions. Besides business cycle-induced funding for short-time work there is also seasonal funding for workers of companies in the construction sector who receive compensation for bad winter weather.

Now lets take a look at how things are done elsewhere. In Italy there are basically two types of unemployment benefits:

1) The Ordinary Redundancy Fund (cassa integrazione ordinaria) which applies in case of events such as a market crisis, i.e. problems not related to particular workers or individual employers, and offers a maximum of 12 months in 2 years, and a maximum of 3 months continously.
2) The Extraordinary Redundancy Fund: this comes into operation when production stops completely (in the event of serious sector crisis, bankruptcy, ...), and the employer decides to ask for state support. The Fund offers up to 36 months in any 5 years period and applies only to firms with more than 15 employees.

Now, according a recent Italian public TV programme on the misuse of Redundancy Funds in Italy, a lot of companies - especially in some areas of Southern Italy (and in Puglia in particular) - are directly cheating the state, by sending their workers home under the Redundancy Fund procedure, and then re-employing them "in an informal way" and paying them under the counter (UTC employment?).

So, the state is paying to the workers - lets say - 600 € from the Redundancy Fund, the employer 250-300€ under the counter, and the company can keep going. In this way workers get approximately 100% of their full-time salaries, and the Italian government doesn't need to announce any special "stimulus" measures which might make ratings agencies nervous.

According to the economist Tito Boeri, interviewed during the report:

- the Italian underground economy is around 15-17% of the Italian GDP, 300 billion €/year. Some estimates: up to 25% of the GDP
- that means at least 100 billion €/year less income from taxes for the state
- the industries living from the underground economy are profiting from the state aid, in this way distorting the market and undermining the future of more productive companies
- in Italy the unemployment benefit system does not work effectively
- many people with a university degree and working in Italy are hiding their qualifications to get a post for which they are over-qualified
- growth in the Italian economy is essentially driven by growth in low-qualified jobs

Well, as I said, there are many ways to skin a skunk, and perhaps this particular one is what Italian Finance Minister Giulio Tremonti had in mind when he recently stated that that Italy may not be faring as badly as GDP figures suggest because they don’t include the so-called black economy, worth about 17 percent of overall economic output.

Europe's Economic Contraction Intensifies In February

2009-02-20T14:19:00.001+01:00

Hopes that Europe's battered economies might be about to turn themselves around took another sharp knock today (Friday), as the preliminary flash reading on the purchasing manager survey signaled that activity in both the manufacturing and the services sectors are contracting at a new record pace in February.

The preliminary Markit euro-zone manufacturing purchasing managers index, or PMI, fell to a record low of 33.6 in February from 34.4 in January, while the services PMI also fell to a record low, dropping to 38.9 from 42.2 in January. As a consequence the euro-zone composite PMI reading dropped to its own record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one. If we consider that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). Not quite Japan territory yet, but not far behind. And for those who simply don't believe the PMIs can tell you so much, here is Markit's own chart, showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. Pretty impressive I would say.

Germany's Contraction Intensifies

The German service PMI came in at at 41.6, showing the fifth consecutive month of contraction. This was a sharp drop from last months 45.2 reading, and means that the recession is now feeding through from manufacturing to services. The difficult conditions have lead service business owners to hold to the grimmest outlook in the last decade, that is since the index was started. More ominously, the recent data points to a strong reduction in the employment level.

On the other hand February saw the tiniest of upticks in the manufacturing sector, since the PMI came in at 32.2, from January's 32 , the best that can be said here is that the rate of contraction may have stabilised.

France Holds Up Slightly Better Than Most

In France, the manufacturing sector (see chart below) gave up on most of January's rebound, and the PMI fell to 35.4 from 37.9 in January, while services (see chart above) slipped to a record low of 40.1 from 42.6 in January. Nonetheless France is visibly performing rather better than Germany, and when all this is over we will have plenty of time to hold the debate as to why that has been.

The EU Bonds Story Rumbles On

2009-02-18T23:40:00.000+01:00

Wolfgan Munchau was complaining only last weekend about the extraordinary narrow-mindedness of Europe's economic and political leadership in the face of the current financial and economic crisis, from Ireland in the West to Hungary in the East, and from Greece in the South to Sweden in the North. But more than narrow mindedness what we are faced with is innocence and inability to react, and frankly I am not sure which is worst. I say "innocence" because it is by now abundantly clear that they simply haven't yet grasped the severity of the problems we face (in countries like Spain, or even Germany itself, let alone in the East), and I say inability to react, since they are always and forever moving too little and too late. The initial response to the banking crisis last October was one example (where we saw a landshift-style volte face in the space of only one week) and the way we are now confronting the need to live up to the promises then made about guaranteeing the banking sector, and in particular the "systemic" banks, would be another.

The complete confusion which seems to reign over at the ECB about whether or not the Eurozone can operate some sort of US/Japanese style quantitative easing would be a third.

Only today we are faced with yet another example of how our leaders are meticulously dangling their toes in the icy water where a more seasoned mariner would simply see the need to dive straight in and rescue the drowning man.

It is reported this morning that Germany and France are now contemplating the possibility of bailing-out entire nations, rather than simply individual banks, as European government budget commitments steadily mount-up while their sovereign debt ratings start to buckle under the weight of a growing and deepening European recession.

As reported in my post yesterday (here) German Finance Minister Peer Steinbrueck became the first senior European politician to broach the topic earlier this week, when he stated that some of the 16 euro area nations are now “getting into difficulties” and may need help, citing Ireland as an example. French officials are also reportedly concerned about how the current "stand alone" sovereign debt situation is leading to widening spreads on Austrian, Irish, Greek and Spanish debt as the cost of insuring against default rises to records. What we have before us is not simply a case of seeing "fiscal irresponsibility" punished, it is a mechanism whereby the eurozone can be peeled apart, and where those states who enter a negative economic growth-bank bailout-fiscal deficit dynamic which means the cost of financing their debt (and thus their bank bailouts) rises so prohibitively that it virtually excludes the possibility of giving further fiscal stimulus to their sinking economies, and does so in such a way that a self reinforcing (and self fulfilling) process may be produced, a process which only leads in one direction and to one conclusion: that of sovereign default.

The problem is that it is not just one or two quarters of negative growth we are talking about here, we are talking of deep depressions, and ones during which deep structural damage can be inflicted on the economies of those states who are hardest hit.

“When push comes to shove Germany, France, the larger players will bail out those smaller peripheral players,” said Alex Allen, chief investment officer of Eddington Capital Management. “You can’t let one part of the system fail because it leads to failure of the whole system.”

European deficits have evidently surged enormously this year as governments are faced with the need to provide funding for the heavily strained banking system and provide some kind of stimulus to their rapidly contracting economies. EU member states have already committed more than 1.2 trillion euros in an attempt to save the banking systems from collapse, and it is evident that a second and possibly larger wave of bailouts may now be imminent.

In particular many of us our now concerned that the eurozone bond market could potentially face a crisis similar to that unleashed by the collapse of Lehman Brothers in September 2008. As ECB board member Lorenzo Bini Smaghi put it earlier this month there’s a “risk that the mistrust that there is today in financial markets” is “transformed into mistrust in states.”

“I would be very reluctant to say: ‘O.K., let Ireland or Greece default, the market will sort it out, punish them for their irresponsibility of the past,’” said Thomas Mayer, co-head of global economics at Deutsche Bank AG in London. “They tried it with Lehman and realized that was not a good idea.”

The Spreads Widen

The gap between the interest rates Greece, Austria and Spain must pay investors to borrow for 10 years and the rate charged Germany yesterday rose to the widest since before they adopted the euro. Credit-default swaps on Ireland rose to a record on Feb. 16, climbing to 378.4 points. Greek credit-default swaps, 270 points on Feb. 16, show a 4.5 percent chance that the country will default in the next 12 months, according to ING Bank NV.

Are Bailout's Possible Under Maastricht?

The simple answer to the above question is most emphatically yes, under article 119 of the Treaty. As follows:

Where a Member State is in difficulties or is seriously threatened with difficulties as regards its balance of payments either as a result of an overall disequilibrium in its balance of payments, or as a result of the type of currency at its disposal, and where such difficulties are liable in particular to jeopardise the functioning of the common market or the progressive implementation of the common commercial policy, the Commission shall immediately investigate the position of the State in question and the action which, making use of all the means at its disposal, that State has taken or may take in accordance with the provisions of this Treaty.

Which in plain English basically means, through you go with your proverbial coach and horses. Indeed they may well have already been driven through, last November, in the case of Hungary.

“The European Commission stands ready to provide a loan of €6.5 billion to Hungary,” the EU executive said in a statement on Wednesday (29 October), adding that “the concrete modalities will shortly be finalised in cooperation with the Hungarian authorities”. Under the plans, the Commission will borrow money from the markets using EU-denominated bonds and then lend it to Hungary, without drawing from the EU budget. The facility is established under Article 119 of the Treaty.It is the first time that Brussels has used the instrument to help an EU country (see background). The facility foresees an overall ceiling of €12 billion of outstanding loans. This funding is limited to EU countries which are not part of the euro zone.

The €12 billion ceiling currently provisioned for in the bond facility has not so far been reached, but it has long been evident that other Eastern EU countries would need to draw from the facility for financial help. Thus it is hardly surprising to learn that French President Nicolas Sarkozy had already proposed raising the ceiling to €20 billion at an EU summit on 7 November.

"I will propose on 7 November that the European Union itself, which has 12 billion available to support a certain number of liquidities and to support a certain number of states, should go up to at least 20 billion (euros) to increase our capacity to respond to the crisis," Sarkozy said, according to Reuters.

As one EU official told journalists at the time "the Commission could also change the regulation and lift the ceiling". Or, in other words, when needs must, it will.

A Little History

The principle of borrowing money from financial markets on behalf of the European Community has previously been applied to grant aid to extra-EU countries, in particular before the 2004 enlargement. Kosovo, Moldova and Georgia are all currently receiving financial help through EU loans raised on the market. In January 1993, Italy, a member of the European Community (the EU's forerunner), was granted an eight billion ECU loan to support its strained balance of payments. Since then, no member state has received financial help through this instrument.

The idea of borrowing money via the issue of EU bonds was first launched by former Commission President Jacques Delors via his 1993 plan for growth, competitiveness and employment. Delors initially wanted EU bonds to fund the European budget. But the majority of member states opposed the idea, fearing it would ultimately increase their expenditure on the Community budget.

Borrowed money has been used by the EU to fund projects in several cases, although the amounts involved have been small. For instance, a 'New Community Instrumentexternal ' was used in the late 70s and early 80s to help regions affected by earthquakes in Italy and Greece. Italy has recently proposed using European bonds to fund key EU projects, but the idea garnered little support

The gateway for the coach and horses is also being prepared on another front, as the Financial Times reports this morning. In this case we are talking about the European Investment Bank, which, according to the FT, is set to lend the European car industry 7 billion euros in the first half 2009 to support the manufacturing of environmentally clean vehicles. This is already a substantial increase on the approximately 2 billion euros a year the bank extended to the industry before the crisis, and there may be more, much more, to come. Pathways are being prepared, even as the wheels on the coach are oiled and the horses' mains groomed.

Philippe Maystadt, the bank’s president for the past decade, revealed the €7bn figure to the Financial Times, as he explained the EIB’s plans to shoulder a bigger financing burden in crisis-hit Europe. Member states have already asked the EIB to increase its annual lending programme by €15bn ($19.2bn, £13.3bn) to €63bn for this year and next in an effort to revive the economy.

So Why The Criticism?

So why, if there behind the scenes so many preparations are now being made did I start this post by saying that more than narrow mindedness, what I felt we were faced with is innocence and an inability to react? Well basically, because I think that Europe's leaders are still in general denial on the scope of this problem. We are not talking simply of little cases, like Greece and Ireland, we are talking about potentially much harder chestnuts to crack, like Spain, and Italy, the UK, and even Germany itself. Remember Germany's economic is now contracting at an almost astonishing pace, and German bonds are getting harder to sell all the time.

The full extent of the problems in the German banking system, as defaults mount in Spain and Eastern Europe, is yet to be measured. Only today German Chancellor Angela Merkel’s Cabinet approved a draft bill allowing the state to seize control of property lender Hypo Real Estate Holding AG, paving the way for the first German bank nationalization since the 1930s. And the volume of assets thought to be likely to need to be bought by any bad bank (or banks) created is very large. Hypo's loans alone are thought to total almost 260 billion euros, and numbers in the 400 to 600 billion euro range are being mentioned. So the fear here is not that a German sovereign default is looming, but that German debt may no longer maintain "benchmark" status, and thus the rate of interest the German government may have to pay to maintain its debt may rise, again impeding efforts to help maintain the economy afloat, and almost inevitably biting into the country's already strained health and pension systems.

Finance Minister Peer Steinbrueck was quoted by the Frankfurt Allgemeine Sonntagszeitung weekly newspaper as saying he could "not imagine (the establishment of a "bad bank") economically or above all politically". A bad bank would need to be financed with 150 billion to 200 billion euros of taxpayer funds, he said. "How am I supposed to present that to parliament? People would say we are crazy." Steinbrueck said no one could predict whether the rescue fund would need to be expanded given mounting losses at banks, but noted it still had room to distribute more money.

And one last example for today, of how the one half (the Commission) doesn't know what the other half (the Nation State leaders) is up to. Joaquin Almunia (who is so often "really out to lunch" on economic issues, he is, as they say "challenged" by the complexity of macro economics, see for example this post here) has warned that Brussels could take action soon against EU member states which let their budget deficits rise above the 3% threshold (see P O'Neill post here).

The EU's executive arm plans Wednesday to examine the budgetary circumstances of several countries, including France, Germany, Greece, Ireland, Malta, the Netherlands and Spain, to see whether action is needed. Most of them, notably France, Greece and Spain, have already forecast that their deficits will blow out beyond three percent of gross domestic product (GDP) -- the limit set out in the EU's Stability and Growth Pact.

France, which has called for the EU limit to be eased as governments grapple with the worst economic downturn in decades, has said it expects its deficit to be 3.2 percent GDP in 2008 and 4.4 percent in 2009. Ireland's deficit is expected to blow out to 5.5 percent in 2008, and then 6.5 percent in 2009, with Dublin hoping to bring things back into line in 2011. Spanish authorities expect a deficit of 5.8 percent this year. Germany, Europe's biggest economy, has forecast three percent this year but believes the figure could grow to more than four percent in 2010. Greece, for its part, foresees a deficit of 3.7 percent in 2009. The Netherlands is due to publish its latest figures Tuesday and might just scrape through.

Given the difficult, and unforseen, pressure we are all up against, this is, quite frankly ridiculous. Not that rising fiscal deficits, and rising debt to GDP ratios, are something we should be casual about, but I think what we need is a certain loosening of the rules in the short term, to be followed by a much stricter tightening as we move forward. And do you know the mechanism I would use to discipline the reluctant states when it comes to paying off the accounts run up during the emergency? Why yes, you've got it, the availability of those much-easier-to-finance EU backed bonds.

You see while the first argument in favour of EU bonds may be an entirely pragmatic one, namely that it doesn't make sense for subsidiary components of EU Inc. to be paying more to borrow their money when the credit guarantee of the parent entity can get it for them far cheaper, the longer term argument in favour is that it may well enable the EU Commission to become something it has long dreamed of becoming - an internal credit rating agency for EU national debt. Basically in the mid term the EU bonds system can only work if it is backed by a very strong Lisbon type reform pact for those countries who apply to make use of the facility. This is what now needs to be worked on. And how do we know that that there won't be yet another round of backsliding on all this? Well we don't, this is the risk we just have to take, but sometimes you do need to simply cross your fingers and jump, since the burning building behind you looks none to attractive either, but what we do know is that since there will now be a mechanism whereby the bad behaviour of the few really can penalise the many financially, then there really will be some meaningful incentive to generate a pact, this time, that really has teeth to stop that penalisation taking place.

Italy's Recession Deepens

2009-02-13T19:17:00.003+01:00

Italian fourth-quarter gross domestic product declined at the fastest quarterly rate in nearly 30 years, sending Europe's fourth-largest economy off into an even deeper recession. According to ISTAT preliminary estimates, Italian GDP fell 1.8% between Q3 and Q4 in seasonally adjusted and weighted daily average terms. If confirmed, the quarterly decline would be the sharpest recorded since 1980.GDP fell in the previous quarter by 0.6%. Year on year, overall output in the Italian economy dropped by 2.6% in Q4, down from both the 1.7% contraction expected and Q3's annualized fall of 1.1%.

Across 2008 as a whole, the Italian economy fell 0.9%, ISTAT said, the most pronounced decline recorded since 1993.The Italian economy officially fell into recession in the third quarter of 2008. And one more interesting detail, Italian GDP is now back at the same level it was in Q4 2005, and falling. This is pretty worrying, and even more so given there are quite a lot more people in Italy then there were in 2005.

Italy Needs EU Bonds And It Needs Them Now!

2009-02-07T16:32:00.000+01:00

You see, this isn’t a brainstorming session — it’s a collision of fundamentally incompatible world views.
Paul Krugman

As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?
Paul Krugman

First, focus all attention on reversing the collapse in demand now, rather than on the global architecture. Second, employ overwhelming force. The time for “shock and awe” in economic policymaking is now.
Martin Wolf

OK, I think no regular reader of this blog could seriously suggest I have much sympathy for the sort of views you normally find being propagated by Italy's Finance Minister Guilio Tremonti, but when he starts to send out the kind of red warning light danger signals that he has been doing over recent days, then I think we should all be taking note, and when the republic is in danger, then its all hands to the pumps, regardless of who is sounding the alert. This is not a brainstorming session, it is a real flesh and blood crisis.

Perhaps few of you will have noticed it, but our erstwhile logician has been getting extremely nervous in recent days, and most notably chose his visit to Davos to indicate that he personally would look extraordinarily favourably on any move to inititiate the creation of EU bonds (for a brief explanation of why these are important, see Wolfgang Munchau's argument in favour of such bonds here. (Or the longer version here)

Italy's Finance Minister Giulio Tremonti has said he favoured the issuance of government debt by the European Union. "Now my feeling -- I am speaking of a political issue not an economic issue -- is ... now we need a union bond," Tremonti said at the World Economic Forum in Davos. Countries in the euro zone currently issue sovereign debt in their own name, rather than regionally. Bond traders concerned about the mounting public debt of Italy, Greece and Ireland have pushed down the value of their government bonds, sparking speculation they might be driven out of the euro zone.

Now why would he be arguing this? Well the state of Italy's own banking sector would be one part of the explanation, and the fact that the Italian government is in no position to mount a rescue operation on its own given the size of its existing debt to GDP commitment, would be another. In particular, and as I have been arguing, Unicredit - and its Eastern Europe exposure - is a huge worry.

Indeed the situation is now so delicate, that according to this Reuters report last week, Unicredit really doesn't know which government to turn to. The Italian one perhaps, or the Polish one, or "it could consider doing it in Austria".

Italian bank UniCredit is considering requesting state support in Italy and Poland, a source close to the bank told Reuters on Thursday. "The bank does not exclude possible state support in Italy and Poland," the source said on condition of anonymity. In an extract of an interview to be published in Germany's Handelsblatt newspaper on Friday, UniCredit Chief Executive Alessandro Profumo said the bank could consider "state support as insurance against unpredictable events." If the bank does seek state aid, it could consider doing it in Austria, for example, he added.

UniCredit SpA is considering asking for government capital amid the credit crunch, Chief Executive Officer Alessandro Profumo said. “State support as insurance for unforeseeable events” is conceivable, Profumo told Handelsblatt newspaper in an interview at the World Economic Forum in Davos, Switzerland. A UniCredit official confirmed the comments to Bloomberg. Italy’s top bankers met with central bank Governor Mario Draghi last week to discuss the financial crisis, which has caused bankruptcies and government bailouts across the world, while stocks have plunged and credit markets have seized up. UniCredit and some of its rivals have tumbled in Milan since the start of 2008 amid concern about the strength of their finances.
Bloomberg 29 January 2009

The announcement that Unicredit was seeking state aid came on the same day that the bank admitted that investors had placed orders for only 0.5 percent of the shares they were offering in a rights issue. The bank received orders for a mere 14.3 million euros of stock out of a total of 3 billion euros, and the plan was to sell leftover stock in the form of convertible bonds, but even this hit a snag, as

The shares were offered at 3.083 euros apiece, or over twice what they were trading for in Milan at the time (around 1.408 euros). Shareholders, including Allianz SE and the Central Bank of Libya, are among those who agreed to buy the convertible bonds, according to the bank offer document. Shares of UniCredit have dropped 54 percent since October, when the rights offering was announced, amid concern the capital raising won’t be sufficient. But even the bonds issue is running into trouble, since Il Sole 24 Ore reported that Unicredit may raise only 2.5 billion euros rather than the full 3 billion euros because because investor Fondazione CariVerona, which holds a 5 percent stake in the bank, reportedly hasn’t received approval from the government to buy the securities, however, the reason they have not received approval may well be that they have not yet applied since the Italian Treasury, in what is a rather unusual step, said on Thursday announced that they had yet to receive a request from CariVerona to sign up for the bond issue. All this suggests, of course, that Tremonti's warning about an imminent bailout could be a piece of brinksmanship, designed to presssure CariVerona to stop playing "positioning" games and come up with the money, but irrespective of whether or not this is the case, some sort of rescue operation for Unicredit surely cannot be far away at this point.

And the fact that Bulgaria's Finance Minister Plamen Oresharski was running around last week assuring everyone that Bulgaria's banks have not asked for state rescue aid so far, and that the government is not worried about the banking system's health for now, is hardly helping to calm already troubled nerves. About 80 percent of the 29 commercial banks operating in Bulgaria are foreign-owned, with the biggest lenders being run by Italy's UniCredit, Hungary's OTP Bank, Greece's National Bank of Greece and Austria's Raiffeisen.

And only today Tremonti has warned that the announcement of more EU bank bailouts is imminent, and maybe as early as this weekend.

European governments may have to bail out more banks as soon as “this weekend,” Italian Finance Minister Giulio Tremonti said today. “So far in Europe there have been more than 30 bank bailouts and I can’t rule out that there will be more this week- end,” Tremonti said, speaking at a press conference after today’s Cabinet meeting in Rome.

So how should we address this danger, imminent or otherwise? At this point in time I have four proposals:

a) The creation of EU bonds
b) The introduction of quantitative easing by the ECB (quantitative easing is the monetary policy which is currently being applied in both the US and Japan, and probably soon in the UK too).
c) Letting those members of the East who want to join the eurozone immediately do so.
d) A new "pact" - one which would be much, much stronger than the old Stability and Growth Pact - to be signed by all countries who enter the EU bond system, a pact which gives direct fiscal remedies to Brussels in the event of non-compliance together with a substantial dose of effective control over the economies of individual countries - since nothing, Mr Sr. Tremonti, ever comes completely for free.

Obviously all of this is quite radical, and indeed fraught with danger, but these are hardly normal times. In all of this (d) is obviously the most important part, as any protection given to EU member economies by the Union must be credible and serious. So no country could or should be forced in, but it should also be pointed out to those who chose sovereignty and remaining on the fringes to participation that they would run an enormous risk. Since almost all EU economies seem vulnerable at this point, anyone staying outside could rapidly see themselves exposed to the risk of forced default, since lack of protection is simply an invitation to attack. Letting ourselves get picked off one by one is not an appetising prospect (Latvia, Hungary, Greece, Austria, Italy, Spain, Ireland, the UK, Romania, Bulgaria.........).

Clearly those who wish to remain "dissenters" should have the liberty to do so, but they should bear well in mind that should they do so they could very easily end up in a group - possibly lead by Diego Armando Maradona - together with Yulia Timoshenko (Ukraine), Cristina Fernadez (Argentina), Rafael Correa (Ecuador) and (possibly) whoever is the new prime minister in Iceland, bankrupt, and without the aid of international financial support to help deal with their mess.

Perhaps readers may think I am being rather shrill here, and perhaps at this point Tremonti (for whom I have no afinity, elective or otherwise, see linked post above) is only playing brinksmanship, but if he isn't, and Unicredit is about to need bailing out, then push does quickly come to shove, since the EU leaders agreed on October 12 in Paris to bail out systemic banks, and Unicredit is a systemic bank. So will will need to know how they plan to stand by their commitment, and if they don't, well then everyone of us stands exposed, since credibility rapidly falls towards zero.

Maybe this is a false alarm situation, and Unicredit will not need bailing out this weekend, or the next one, but one day it will, and one day Spain's huge non performing loan and household debt default problem is going to need sorting out. So I think this is a line in the sand situation, and we are much nearer to having to make up our minds which side of the line we are on than many seem think.

To paraphrase Paul Krugman again, in flirting with the idea of whether the first to default should be Greece, or Hungary, we truly are flirting with disaster.

You are independent of all logic Giulio Tremonti!

2009-01-21T23:42:00.001+01:00

Italian Finance Minister Giulio Tremonti is a strange and controversial figure.The peculiar phrase in the title to this post in fact came out of the very mouth of Tremonti himself, though they were addressed to an astounded, if now world famous, US economist, Nouriel Roubini, in front of an equally amazed and bemused Davos audience. Since in these kind of matters it is normally better to watch what it is you actually say, just in case in the fullness of time your own words come back to haunt you - as the famous “If you don’t fully understand an instrument, don’t buy it” ones of Santader Bank chief Emilio Botin just did in the Madoff affair - I simply can't resist pointing out how lacking in logic the present Italian Finance Minister is himself at times.

This post came into my head on reading a report in the Financial Times, about a plan which Italy, currently the revolving (how appropriate this word is here) president of the G7, wishes to present to that august body, with the apparent intention of promoting all that much needed reform in the financial system. I was almost moved to tears by the elquoence and idealism of his words, and of his determination to get to grips with all those horrid "rogue economies".

We need a new global order,” (Tremonti) told the Financial Times in an interview. “We want to present a new icon – the legal standard – just as once there was the gold standard" A briefing paper he showed the FT begins: “The ‘Legal Standard’ could contain the minimum basic set of rules on propriety of international activities and transparency which the whole international community is expected to respect.” A mix of voluntary and binding codes would be closely monitored with a wide range of tools, including peer review, naming and shaming, indicators and “black listing ... for ‘rogue’ economies”.

But then I put my emotions to one side, and thought cooly and calmly for a moment: coming from a minister whose country ranking in the World Economic Forum Global Competitiveness Report lies somewhere near to that of Botswana (with all due respect to Botswana) this does seem all to be rather rich to me, my, my, it really does.

But then I read a report of an interview Tremonti gave last week to the French newspaper Les Echos:

Finance Minister Giulio Tremonti told French newspaper Les Echos in a Jan. 12 interview that Italy may not be faring as badly as GDP figures suggest because they don’t include the so-called black economy, worth about 17 percent of overall economic output, according government estimates.

And I thought to myself, mightn't an economy where the Finance Minister brazenly proclaims that 17% of output is to be found in the informal economy......well mightn't someone think that a country whose minister cited this fact as evidence for not doing too badly was itself one of those "irregular" economies that Tremonti wants to set us all so hard to work on "blacklisting". But then I read the latest utterance from his Prime Minister Silvio Berlusconi, and I understood what not faring badly actually means in a country whose politicians' grasp of the complexities of modern logical thinking leaves me just astounded:

Italian Prime Minister Silvio Berlusconi said the economy isn’t in “such bad shape” even after the European Commission and the country’s central bank predicted the worst annual contraction in more than 30 years. “It means we will go back by two years,” Berlusconi told reporters today in Rome, referring to the value of nominal gross domestic product. “That doesn’t seem so bad.”

Indeed, Giulio Tremonti does have this much in his favour, he never flinches in the face of having to change his mind. Only today he came out and abandoned his forecast (yes, only today) that the Italian economy would expand in 2009 and informed us that it is about to have the worst contraction in more than 30 years. Of course, it is just mere coincidence that the European Commission yesterday forecast a contraction of a similar order.

Interestingly here, Tremonti came out on 18 December and explicitly attacked the Financial Stability Forum, a group of regulators chaired by Bank of Italy Governor Mario Draghi. In comments to reporters at the European finance ministers and central bankers held in Paris, he insisted it would be “stupid to listen or take lessons from people who don’t understand anything” of the credit crisis. Ironically, one of these people - Mario Draghi - who apparently didn't understand anything had already forecast on January 15 that the Italian economy would contract by 2% this year (at the time Tremonti was predicting 0.5% growth). When question by reporters about the apparent disparity he limited himself to saying that The Bank of Italy forecast seemed “realistic”, but that the government’s own predictions were not yet ready. I mean, I know Liebniz and Newton did reputedly discover the mathematical calculus separately, but it is curious how the Bank of Italy, the EU Commission and the the Italian Government all come out with exactly the same number within a matter of days. Could this be another example of multiple scientific discovery, or is it just that they are using the same computer software and model.

Go Back To Turkey!

Moving back now to Nouriel Roubini and the Davos Meeting of 2005, I think I'll let Nouriel himself develop the point. As he put it on his blog at the time:

On Friday I was in Davos in a panel on the "Ups and Downs of EMU" (European Monetary Union) where ECB head Trichet, Italian Economy Minister Tremonti, a few other EU officials and myself were supposed to discuss the following questions: Will EMU collapse in the future? Which country will exit first? What will be the consequences of a break-up of EMU? How to avoid that? And what are the prospects for the Growth and Stability Pact? Unlike the other panelists that ignored the topic and spoke instead about all the good things allegedly associated with EMU, I took the questions seriously by considering some of the problems and risks faced by EMU and the risks of a break-up, especially for the case of Italy.

My remarks caused a stir with Minister Tremonti who interrupted me in the middle of my remarks, went into a temper tantrum and shouted - to the consternation of all participants - to me: "Go Back to Turkey!!". I happen to have been born in Istanbul.....I politely replied that I was an independent academic thinker being paid to present sensible analyses and arguments. And I also pointed out that Prime Minister Berlusconi, the boss of Mr. Tremonti, had declared in public that the "Euro has been a disaster for Italy". At which the minister rudely interrupted me again shouting: "You are independent of logic". At that point I decided to ignore him and finished my remarks. The only additional observation I can make now is that the minister did not just personally and rudely insulted me; he also insulted Turkey and the Turks, a civilized country that is following much more radical fiscal policies and economic reforms than Italy in order to join the EU. Moreover, such a public temper tantrum by the deputy prime minister of Italy - something apparently common to him as the italian press has reported - is a major embarrassment for Italy; Italy deserves better in terms of who should lead its economy and represent him in international public forums. As many members in the audience expressed their solidarity to me and their scorn of the minister tantrum after the end of the panel, this sad episode is a reflection of the sadder state of economic policy in Italy. And the Italian press, starting with the respected Corriere della Sera, has now reported this sad incident and scorned the minister for publicly embarassing Italy in a major international forum. Hopefully, since Italy and Italians deserve better rulers than this buffoon that made a fool of himself in public and embarrassed his own entire country, in April they will vote into the dustbin of history this mediocre individual and his entire administration. Certainly with pathetic rulers such himself Italy would be certainly bound to face economic disaster and eventually be forced to ignominiously exit EMU. Italy and Italians deserve better.

But such volte face from GuilioTremonti are nothing new. Take his new found enthusiasm for the euro, for example - in fact only this week he decried his own Prime Minister's earlier view that the Euro was a disaster, and asserted that in his opinion the euro project was a “totally sustainable” one. A conviction which now stands in somewhat strange contrast with the large queues which developed outside banks and ATMs in Italy during the first days of the new currency's existence since due to his then "eurosceptic stance" as economy minister there were marked delays in the introduction of the currency and a huge row about who was to blame in the Italian cabinet. In fact the row lead to the abrupt exit stage left from the Italian government of Foreign Minister Renato Ruggiero who was strongly critical of Tremonti's antics, antics which were implicitly defended by Prime Minister Berlusconi himself in allowing Ruggiero to be ousted.

And I could go on and on, citing, for example, his recent statements to the effect that further stimulus packages have no point since they simply don't work, an attitude which looks rather less the standpoint of a man of principle, and rather more like sour grapes from the Finance Minister of a country which quite simply can't afford any more stimulus due to the imminent threat of credit rating downgrades. The Europen Commission has said it expects Italy’s public debt to rise to 109.3 per cent of GDP this year, up from around 105% next year. This is what happens when you get a 2% contraction, and if we get deflation (falling prices) then things will get even worse without any increase in the actual deficit, and let's try not to think about what the rising cost of borrowing indicated by the credit spreads will mean.

“It’s not right to support demand by raising debt,” Tremonti said in a news conference in Rome. “The economic trend can’t be turned around with stimulus packages. Judging from the U.S., they have worked very little.”

As I said, I could go on and on, but at this point my head is simply spinning with this whirling-dervish-like crasp of the niceties of logical reasoning, so I think I'll leave it there. After all, we do have a crisis out there which we need to make the time to think about.

Italy Slips Slowly But Steadily Into Its Worst Recession In Over 30 Years

2009-01-16T12:52:00.003+01:00

The Italian economy continued to contract sharply in the third quarter of 2008 as exports fell sharply - declining at the fastest rate in three years - under the impact of a global slump which weighed down on foreign demand for Italian products, and pushed the Italian economy into its worst recession since at least 1975. Sales of Italian goods abroad fell 1.6 percent from the previous quarter, their biggest decline since 2005.

Pressure is of course on the government to offer a fiscal reponse to the problem, but given Italy's outstanding debt issues and the fact that a large part of the problem is long term structural and not cyclical it is hard to see much of note happening, and indeed Finance Minister Giulio Tremonti's statement this week that additional stimulus packages were pretty pointless could be read as more of an admission of impotence than anything else. What'smore the Italian government announced this week that its budget deficit for 2008 will be 52.9 billion euros, somewhat above the government’s earlier estimate which forecast a gap of 45.2 billion euros. It is not clear yet how this deficit overrun will actually affect the final % of GDP number for the deficit, since we still do not have an accurate 2008 GDP number for Italy yet. In any event speculation is rife about the future of the Italian bond spread and the danger of a credit rating downgrade. The Italian government went to market this week and sold 6.949 billion euros of five-, 20- and 30-year bonds. The 10-year Italian BTP/Bund spread was trading at around 144 basis points after Thursdays auctions compared with 141 basis points the day before.

Severe Limits On Stimulus Packages and Bank Bailouts

This week the government did approve a further 16.6 billion euros in public works investments to try to boost economic growth, but little of this actually represents new spending. The projects include an additional 7.3 billion euros in public spending, together with 9.3 billion euros in private investment. Among other infrastructural works some of the additional funding will go toward building the “Moses” retractable dams that are designed to protect the city of Venice from flooding.

This infrastructure package is in addition to the 5 billion euro stimulus package to help poor families, small businesses and boost bank capital that was agreed to by the Italian parliament earlier in the week. Under the bill a sum of around 2.4 billion euros will be used to help Italy’s poorest families and pensioners, including some one-off cash payments. Highway tolls will be frozen until April 30 and low-income Italians will benefit from tax breaks on utility bills. Small businesses will get a 10 percent break on a regional tax on condition they are already paying a national corporate income tax.

Following warnings to a number of Eurozone government's over credit downgrades from rating agency Standard and Poor's this week Finance Minister Giulio Trementi said on Thursday that Italy won’t follow up its existing stimulus package with more cash injections . Italy currently has the highest debt level in the European Union, which was running over 105 percent of gross domestic product in 2008, according to a Bank of Italy statement today.

Italy’s bank bailout is likely also to be pretty modest in comparison with what is going on elsewhere. The 20 billion-euro bank recapitalization plan will probably start operating next week, according to the news source Il Sole/24 Ore, but details are not available since the Finance Ministry is still “perfecting” the rules and regulations that go with it.

Bleak GDP Growth Outlook In The Short, Medium and Long Term

Italy's economy is expected to shrink by 2 percent this year, making the present contraction the worst in more than three decades, according to the latest forecast from the Bank of Italy. “Taking into account the government measures .... the economy will shrink by 2 percent and then expand 0.5 percent in 2010". The economy’s last annual contraction on this scale was in 1975.

These central bank predictions are the worst to have come out on Italy to date, and significantly above the 1.3 percent contraction being forecast by employers organisation Confindustria and minus 0.6 percent prediction from retail lobby group Confcommercio. It is also a substantial downward revision since only six months ago the central bank was predicting growth of 0.4 percent. Ominously Confcommercio added that “Should the employment situation worsen, we will have to cut these estimates”. Clearly one of the big dangers with the current contraction in the industrial sector is that it lead to large a scale industrial layoffs, and that this then feed back pushing demand downwards.

The Bank of Italy forecast was described as “realistic” by Finance Minister Giulio Tremonti even though his current government forecasts are for an economic expansion of 0.5 percent in 2009. These differences in forecasts are in fact very important, since the government budget is evidently anticipating far higher revenue levels and far lower social expenditure (on unemployment etc) than is likely to be the case.

Fourth Recession In Seven Years

The last GDP report from Italy's statistics office (ISTAT) confirmed that the euro-region’s third-biggest economy slipped into its fourth recession in seven years in Q3 2008. The economy shrank 0.5 percent in the three months through September after contracting 0.4 percent in the previous three months. Imports in Germany and France, Italy’s largest trading partners, declined in October, and the German import decline of 5.6% in November over October (following a decline of 3.7% in October over September) was the biggest slide in almost four years. As a result Italian year-on-year GDP shrank 0.9 percent in the third quarter.

Italian imports fell 0.5 percent in the third quarter while consumer spending barely grew, increasing 0.1 percent in the quarter. Year on year household spending was down 0.6%.

Gross fixed capital formation was down 1.9% on the year - with the machinery and equipment component down 3.5%. Exports fell 3.1% on the year in price adjusted terms.

Manufacturing Contraction

And as we look forward all the short term data is deteriorating. Industrial production fell yet again in November with output dropping a seasonally adjusted 2.3 percent from October, while production adjusted for working days fell 9.7 percent when compared with November 2007, the biggest drop since 1991.

And if we look at the index, we can see that output has now been trending down since the end of 2006.

And survey data from December suggest the Italian manufacturing sector remained mired in recession as output, new orders, new export orders, backlogs, employment and purchasing activity all contracted. The headline seasonally adjusted Markit/ADACI Purchasing Managers’ Index (PMI) came in at 35.5 in December. Even though this was marginally up from the 34.9 recorded in November, it was the still second-lowest reading recorded in the history of the survey.

And it was the ninth consecutive monthly contraction in production volumes. In their report Markit state that the continued downturn in new business appeared to be the key driver, as firms reduced output in line with falling demand. Steep falls were reported in new business from both domestic and foreign markets. Overall, new order books fell for a 12th successive month, albeit at a slightly weaker rate than November’s series record. And perhaps most worryingly given Italy's need to export, new orders from export markets fell at the fastest pace in the survey history.

Protracted falls in incoming work and production volumes resulted in a further month of job-shedding in December. Moreover, the rate of job losses was the fastest in the history of the series. There was also some evidence from those interviewed that redundancy programs had been implemented over the month and that the non-essential workforce had been reduced.

Commenting on the Italy Manufacturing PMI survey data, Andrew Self, economist at Markit Economics, said: “While December’s fall in output was less pronounced
than November’s series record, the rate at which the manufacturing economy has
contracted throughout Q4 is alarming. Italian manufacturers will hope that the
fiscal packages announced throughout Europe in December will mark the turning
point of the recession. However, with new orders still falling in domestic and
foreign markets the downturn looks set to continue into 2009.”

The Services Sector Also Continues to Contract

Italy's service sector also contracted sharply in December (for the 13th consecutive month), although as with manufacturing the rate was marginally slower rate than the record low hit in November, and the Markit Purchasing Managers Index edged up to 40.3 from 39.5 in November. Again this was still the second lowest level in the survey's 11-year history and well below the 50 divide between growth and contraction.

The index has now not been above the 50 mark that separates growth from contraction since November 2007 and the latest survey, like its companion PMI for the manufacturing sector, offered no evidence whatsoever of recovery.

"December ... painted a gloomy picture of the Italian services economy as,
throughout the final quarter of 2008, activity contracted at rates unprecedented
in the 11-year survey history," said Andrew Self, economist at Markit Economics.

Retail Sales Contract For The 22nd Consecutive Month

Italian retail sales contracted for a 22nd month in December as the Bloomberg retail sales PMI rose slightlly - to 31.9 from 28.5 .The index, based on a survey of 440 executives prepared by Markit Economics, also showed annual sales fell at the fastest pace in the near five-year history of the data.

Declining sales prompted retailers to cut staff for a 12th consecutive month, the report also said, and the rate at which staff numbers were reduced was the fastest since Markit first compiled the data in January 2004. In the third quarter the number of Italians out of work rose and the unemployment rate held at two-year high of 6.7 percent. Joblessness will rise to 6.9 percent in 2008, the highest in three years, from 6.2 percent in 2007, the Organization for Economic Cooperation and Development estimated on Nov. 25.

Falling Consumer and Business Confidence

Italian business confidence fell to a record low in December, and the Isae Institute’s business confidence index dropped to 66.6 from a revised 71.6 in November.

“These figures are consistent with the picture of a deep recession in
manufacturing industry,” said Paolo Mameli, an economist at Intesa Sanpaolo in
Milan. “As there is usually a three-month gap between this data and the
industrial production, we forecast that the economy will contract further next
year and won’t resume growing anyway until the last quarter of 2009.”

About 13 percent of Italian companies trying to get loans don't receive them, either because banks refuse to lend to them or because the costs involved are considered excessive by the company, Isae say in data which accompanies this months report.

Italian consumer confidence also fell in December its level in four months on concern that the recession and the decline in industrial activity would increase unemployment, with the Isae Institute’s consumer confidence index falling to 99.6 from 100.4 in November.

Inflation Falling Back But No Sign Of Deflation Yet

Italy’s inflation rate fell to its lowest level in 14 months in December, as energy costs fell sharply and the recession made it harder for retailers to raise prices. Consumer prices as measured by the EU's HICP rose 2.3 percent from a year earlier, compared with a 2.7 percent rise in November. When compared with November prices were down 0.2 percent.

So Where Does That Leave US - With Very Little (If Any) Growth In the Future, That's Where It Leaves Us!

Unlike many other Eurozone economies, Italy's current contraction in activity is not a simple result of the global economic slowdown. Itay's problems are endemic, and ongoing: hence the four recessions in seven years. Trend growth in Italy has been slowing over the last few decades, and must now be near to zero. Which raises the question as to whether in the coming decade Italy's trend growth could turn negative, with GDP simply contracting from one year to the next.
Obviously this possibility is only a theoretical one at the present time, but it is one which cannot be entirely included, especially when we look at how - despite all the promises that things would change - trend growth has steadily drifted to zero. Ceratinly also there are reasons to imagine that the productive capacity of the Italian population could drop as median population rises. Italy is currently among the three oldest societies on the globe - with median age of 43, and Germany and Japan being the other two - and as we saw at the start of this post, Italy has not been able to raise its export prowess in the way the other two have. And if it hasn't been able to do this over the last 15 years or so, what good reasons are there for thinking that Italy may start now?

S&P and Fitch last reduced Italy's credit rating in October 2006, with S&P reducing the rating to A+ (with negative outlook), the third-lowest of the eurozone countries after Greece and Slovakia, while Fitch dropped it to AA- from AA. Moody’s Investors Service rates Italian debt Aa2, with a “stable” outlook. In November 2005 the ECB announced that would not accept government paper (bonds) in the future from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies. Which means of course that Greek sovereign bonds are now very vulnerable to losing acceptable asset status in the longer run, but that Italy is not far behind.

In fact back in October last year, the ECB announced that the Eurosystem would lower the credit threshold for marketable and non-marketable assets from A- to BBB-, with the exception of asset-backed securities (ABS), and impose a haircut add-on of 5% on all assets rated BBB-. But it is important to bear in mind that this expansion of eligible collateral is temporary: “The list of assets eligible as collateral in Eurosystem credit operations will be expanded as set out below, with this expansion remaining into force until the end of 2009.” While it is perfectly possible that the ECB will extend this temporary relaxation of credit thresholds for the duration of the current crisis, the problem of default risk in the most vulnerable economies is likely to outlive the current crisis, and the ECB relaxation is unlikely to last indefinitely.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has now ballooned to the widest since before they joined the euro. In the graph below you can see ten year bond spreads for Greek, Irish and Spanish government paper as compared with the benchmark German Bund.

The yield on Spain’s 10-year bond averaged 8.5 percent in the six years before it joined the euro and the gap with the equivalent German bond was 246 basis points. In the next eight years, the average yield fell to 4.5 percent and the spread to 13 basis points. That convergence is now being thrown into reverse. In the past week, Standard & Poor’s has downgraded Greece’s credit rating, and those of Portugal and Spain are also under threat. The difference between the Spanish and German 10-year bonds rose to 115 basis points today, the highest since 1997. The spread on Italy’s bond at 144 basis points was the most in 12 years and the Greek spread was the most since 1999.

Different economists take differing views on the implications of this development. The LSE's Willem Buiter argues that the widening of the spreads is a good sign, as it shows that market mechanisms are finally working. In the past the problem had been the way that markets assumed for too long that governments would be bailed out if they defaulted. But RGE Monitor's Nouriel Roubini makes the very valid point that if financial markets get concerned about the risks of exits, a vicious circle of rising rates and poor debt dynamics may force exit regardless of the will to stay in. The effects can be very similar to a currency crisis or a self-fulfilling run on the government debt or the banking system. Basically, countries like Italy and Portugal have quite low trend growth rates as it is, if fiscal support is withdrawn and bond spreads rise this can easily produce a lose-lose dynamic which virtually forces default.

And this is without any reference to the negative feedback effects that can be produced by the health and pension spending required to meet the needs of a rising elderly support ratio, and a lower productivity from a working population with a higher median age. All in all, a very difficult can of worms for everyone to get to work on.

Unicredit Shares Fall Again, Merrill Lynch Downgrades

2008-12-19T12:44:00.007+01:00

At the present time the Achilles heel of the Italian economy has a name, and it is called Unicredit. In a number of posts on this blog (here, here, here, here) I have tried to draw attention to the potential problem the deteriorating balance sheet of what is now Italy's second bank by market capitalisation (after Intesa Sanpaolo) it used to be the first before the shares fell) and first bank by assets, and how this issue is exaccerbated by the fiscal embarassment of the Italian state.

The spread between Italian and German 10-year bonds hovered around 1.36 percentage points on Monday, more than four times its average over the euro's first eight years. Continuing social unrest in Greece has also pushed the gap between the yield on that country's 10-year bond and that of its German counterpart to a fresh high of more than two percentage points (see much more on Greece here).

At the same time, the cost of buying insurance on Spanish, Italian and Greek debt has more than tripled over the past six months, according to credit information firm Markit Group. Even as the market turmoil has eased in recent weeks, the price of such insurance on Southern European debt has continued to increase, touching highs earlier this month. The widening spreads and increasing insurance costs show opinions among investors about the short term outloook now vary considerably between one eurozone country and another.

Such widening spreads mean more expensive bond auctions for the Italian government in the future, and this is just where the trouble comes, since Italy has a very hefty accumulated debt to continually refinance (around 105% of GDP), and it is partly because investors don't see clearly how a government with a damaged banking system and an economy which looks set to shrink for at least two years can continue shoulder the weight of this debt let alone increase it, especially given the evident difficulty faced by the Italian government in enforcing measures to reduce it, that the widening is occuring.

And this is what makes Unicredit such a major headache for the Italian government, since any substantial increase in government borrowing needs could become completely counter productive if it precipitated an increase in the spread and thus an increase in the costs of borrowing over all those parts of the debt which fall due for refinancing.

Unicredit 2008 Earnings Won't Meet Target

Unicredit shares fell in Milan trading this morning after the bank admitted 2008 earnings won’t meet their target. Unicredit shares were down as much as 4.7 percent - to 1.52 euros at one point - their lowest price since 5 December, and were trading at 1.55 euros (down 2.6 percent) in Milan, giving it a market value of 20.7 billion euros. UniCredit said in a statement late yesterday that it expects net income of 4 billion euros in 2008, excluding a property sale that will be smaller than planned. The company in October forecast net income of 5.2 billion euros.

UniCredit recently reached an agreement with unions to offer early retirement to 3,700 workers in an attempt to cut costs amid the global financial crisis, and last week they bank pulled out of an option they had to buy the Polish government's remaining 3.95 percent stake in Bank Pekao in order to not put more strain on the bank's solvency ratios.

Merrill Lynch Downgrade

Unicredit was downgraded to "neutral" from "buy" by analysts at Merrill Lynch this morning. The bank cited “the fast deteriorating macro picture in Italy and Central Eastern Europe”

“The high exposure to Central Eastern Europe and to the corporate business result in UniCredit above average sensitivity to the poor macro environment and to asset quality deterioration,” London-based analysts Antonio Guglielmi and Andrea Filtri wrote in a note to investors today.

Ukraine Clients May Default On 60% Of Loans

A 44 percent slide so far this year in the Ukraine currency, the hryvnia, is threatening the repayment of loans and mortgages denominated in foreign currencies. Roman Zhukovskyi, head of the social and economic department in President Viktor Yushchenko’s office, estimated in a televised press conference in Kiev on Wednesday that if the hryvnia traded near 9 per dollar, some 60 percent of loans may not be repaid.

“A substantially weaker hryvnia is going to seriously hurt corporations since Ukrainian companies have massive external liabilities,” said Ozgur Yasar Guyuldar, a senior emerging markets strategist in Vienna at Raiffeisen Centrobank AG, who forecast the decline to below 9 per dollar in November. “It is inevitable to see dozens of corporate bankruptcies.”

In an attempt to soften the devaluation blow and bolster the currency Ukraine’s central bank raised its refinancing rates for the second time in two days today to 22% after the hryvnia fell as much as 16 percent in the past two days. But this is likely to be of little avail given that the economy is already headed for an estimated 5% GDP contraction in 2009, and these kind of interest rates make any softening of the economic slump impossible.

Of course the meltdown which is taking place in the East at the moment does have its own special surreal dimension, since while Merrill Lynch analysts in Italy are busy pushing down Unicredit's share price, Unicredit analysts in Moscow are busy biting the hand (in Italy) that feeds them by downgrading the Russian property market, and with it the Russian property developers, whose defaults will, in their turn, drive Unicredit's share price in Italy down even further.

Russian property stocks slid in Moscow trading after UniCredit SpA said real-estate prices are so inflated they may need to be halved to lure buyers back to the housing market. OAO Sistema Hals, the developer controlled by Russian billionaire Vladimir Yevtushenkov, slid as much as 11 percent to 319 rubles, as UniCredit called Moscow’s property market “overheated.”

Ukraine is just one - at this point extreme - example of the kind of level of default we can see among holders of forex loans across Central and Eastern Europe in 2009, and Unicredit is in the forfront of the exposure to these defaults, which means, effectively, that the medium term future of the Italian economy at this point in the hands of the CEE countries. Which is why Italy's biggest economic headache has a name, and that name if Unicredit.

Italy's Manufacturing Contraction Accelerates In November

2008-12-01T16:01:00.003+01:00

Italy's manufacturing purchasing managers' index contracted at the sharpest pace in Italian survey history in November. The Markit/ ADACI manufacturing PMI declined to 34.9 in November, reflecting the sharpest deterioration in operating conditions in the sector in the eleven and half years of data collection. A reading above 50 indicates expansion, while a reading below 50 signifies a contraction.

Series record falls were also recorded for output, new orders, export orders, backlogs of work, purchasing activity and employment. At the same time input prices fell for the first time in 40 months in November, with the decline in costs being the steepest since late 2001. Fall in prices of oil based products and raw materials were the key drivers of this decline. At the same time, the factory gate prices registered the steepest drop in survey history, although the rate of fall in these prices was much slower than that of input costs.

Andrew Self, Economist at Markit Economics, commenting on the latest PMI data said "With the Italian economy already in technical recession, latest data from the manufacturing sector indicates that the economic downturn has accelerated markedly through the fourth quarter so far.

Output Down 6.9% In October - Stats Office

This PMI reading is only confirmed by the latest data from the Italian Statistics Office - ISTAT - on industrial output in October. Month-on-month production dropped a seasonally adjusted 1.2 percent - following a revised 2.6 percent drop in September, the national statistics office in Rome said today. Year on year production adjusted for working days fell 6.9 percent.

More significantly, the output index continues to fall month by month, and is now well below that December 2006 historic high of 101.1. Maybe we should be asking ourselves, will we ever get back up there again? Certainly it won't be easy, and not in the present climate.

As Prices Fall In November, Is There A Deflation Risk In Italy?

2008-11-28T12:49:00.005+01:00

Italy’s inflation rate fell to its lowest level in 11 months according to the ISTAT initial estimate out today, as energy costs fall and the economic recession makes it harder for producers and retailers to raise prices. Consumer prices calculated on the basis of the European Union harmonised methodology rose 2.8 percent from a year earlier, down from the 3.6 percent registered in October.

So the rate of disinflation is very rapid - but what about outright deflation, or an actual sustained fall in prices. Is there a risk of this in Italy? Well at the present time it is very hard to say, but month on month prices fell 0.4 percent in November, and the index is thus still at the same level it was in June (see chart below). That is Italian prices have been stationary since June. This is largely due to the negative energy prices shock, but with the sharp contraction in both internal and external demand now facing the Italian economy outright deflation certainly cannot be ruled out at this point.

Italian Retail Sales Fall At Record Pace In November

2008-11-27T12:26:00.004+01:00

Italian retail sales fell at the fastest pace since records began (at least four years) in November as the economy slipped deeper into a recession, and consumer confidence and spending consequently deteriorated. The seasonally adjusted retail purcahsing managers index fell to 28.5 from 34.8 in October, registering the sharpest rate of contraction since the survey began in 2004, according to the Markit Economics monthly report. A reading below 50 signals contraction.

Non price corrected retail sales rose 0.5% year-on-year in September (the latest month for which ISTAT has published data) following a 1.3% fall in August. But we need to remember that once we allow for price inflation, we get a constant price real drop of 3.4% (inflation was running at 3.9% in September, see chart below for the time series). Retail sales of food products increased 1.4% in the month, although this impact was partly offset by a 0.1% fall in retail sales of non-food goods. Month-on-month, seasonally adjusted Italian retail sales (non price corrected) were up 0.3% in September, following a 0.5% decline in the previous month.

With Italy In Recession Consumer and Business Confidence Decline Further In November

2008-11-25T10:57:00.008+01:00

Italian consumer confidence fell back to its lowest in three months in November, with the Isae Institute’s consumer confidence index dropping to 100.4 from 102.2 in October.

“Recession news may have dented household morale more than the market turmoil,” said Marco Valli, an economist at UniCredit SpA in Milan. “In the next few months darkening savings and labor market prospects should add to the gloomy outlook.”

Italian business confidence also fell - to its lowest in more than 15 years - in November, and the Isae Institute’s business confidence index dropped to 72.2 from a revised 76.9 in October.

Italy entered its worst recession since 1992 in the third quarter of 2008. The Italian government is scheduled to present an 80 billion-euro ($101 billion) stimulus plan on November 28, and the government also plans to increase the funding for temporary unemployment benefits as joblessness rises. However with approximately 103% of GDP outstanding in debt and a substantial bank bailout to finance, possibilities for additional counter cyclical spending are limited.

According to the newspaper l'Unita at least 400,000 Italian workers with temporary contracts may lose their jobs by the end of the year, citing data coming from a study carried out by the country’s biggest trade union, CGIL. The union forecasts that almost one in four of the 1.8 million part-time workers in Italy’s private sector will not have their contracts renewed at the end of December.

And the outlook next year seems to be even bleaker. The recession is almost universally expected to deepen ,and the International Monetary Fund forecast earlier this month that Italy’s economy will contract 0.2 percent this year and 0.6 percent in 2009. The IMF itself, in their latest Article IV Consultation Report - published on 20 November - described the outlook for the Italian economy as “bleak.”

“Beyond the present cyclical slowdown, the real economic crisis confronting Italy is the decline in productivity over the last decade, which has spawned stagnating incomes, rising unit labor costs and tepid growth,” the IMF said.

Obviously Italian consumers are getting some relief from the sharp drop in oil prices which means that gasoline and heating costs are falling as is the inflation rate, which has been falling steadily back from a six-year high of 4.1 percent in August. Thus the level of the consumer confidence index is still somewhat above the very low level we saw back in June. But having consumer confidence lying around just above all-time lows is hardly much consolation at this point I think.

The IMF expect Italy's fiscal deficit to widen in 2008. According to the fund the structural fiscal balance improved substantially in 2006-07, but this was mainly due to exceptionally strong revenues - and the overall deficit narrowed to 1.6 percent of GDP in 2007. But, with the 2008 budget anticipating a continued expansion and revenue waning as the recession started to bite, the overall deficit is expected to be close to 2½ percent of GDP this year.

The Italian government three-year fiscal package had targeted a broadly-balanced budget by 2011 - in line with Italy's undertakings under the EU Stability and Growth Pact. The adjustment plan was expenditure-based and targeted a structural consolidation of 0.8 percent of GDP in 2009, increasing thereafter, with the respective public debt and spending ratios falling accordingly. As the fund notes these plans were based on GDP growth rates of 0.5 percent in 2009 rising to 1.2 percent in 2011.

Since these forecasts are now rather outdated the near-term fiscal outlook is expected to deteriorate in line with the present macroeconomic environment. The IMF project a higher fiscal deficit in 2009 due to the weaker growth outlook, with the expenditure ratio rising further, even if the nominal spending limits continue to be observed. In addition, they note the danger that tax elasticities shift adversely during the downturn and expenditure savings are not fully realized. In this case the debt ratio will almost certainly rise further, reflecting the gap between the still-high average interest rate on government debt and falling growth rates, higher deficits, and possible bank support operations. All in all, it will be interesting to see how the credit ratings agencies react to this turn in events.

Unicredit Has NOT Made Losses On The Russian Interbank Market

2008-11-17T22:27:00.003+01:00

Well it must come as something of a relief for any Italian readers I have to learn that UniCredit SpA, Italy's biggest bank by assets, has definitely NOT incurred losses on the Russian interbank market. Although perhaps I should rephrase that by adding just one extra word: yet. UniCredit has definitely NOT YET incurred (significant) losses on the Russian interbank market. This important piece of information is what we can glean from today's statement from Unicredit spokesman Marcello Berni to the effect that "We have no losses on the interbank market....The rumors come from a misinterpretation of news that came out today"

The "misinterpretation" - that lead to a 15 cents, or 7.3 percent, drop to 1.85 euros of Unicredit shares in trading today in Milan - was the result of a report from Moscow-based Interfax to the effect that UniCredit was about to sign an agreement with Russia's central bank to get compensation for losses on interbank operations. The source for the Interfax story was UniCredit Russia Chief Executive Officer Mikhail Alekseyev. But as Marcello Berni points out Alekseyev was referring to possible support the Russian central bank has offered to financial institutions in case of losses on the interbank market, and it should not be read as meaning that such losses had already been incurred, only that Unicredit have hat-tipped the central bank to be readying the money up just in case they do.

The real roots of this problem are to be found in the fact that Unicredit has very substantial exposure to losses in a number of key Central and East European countries, and the Italian government, which already has a debt to GDP ratio of over 100%, is in no position - especially with an economy which looks set to shrink all the way through from here to 2011 - to offer much in the way of cash to support the bank. As I point out in this post, Austria (which is a much smaller country than Italy, but which has similar East European exposure) has already lined up an initial 100 billion euros to support its banks, while the Italian government has remained hesitant to be specific about anything, but seems to be talking about support which only amounts to something like 20 billion euros. So we are left with the rather undignifying spectacle of the leaders of the eurozone's third largest economy having to rely on Muammar Abu Minyar al-Gaddafi and Vladimir Putin for vital support to keep one of Italy's leading banks alive.

Unicredit used to also be Italy's leading bank by market value, but since their stock has now declined by 59 percent in the last six months, and the company's market value stands at 24.7 billion euros ($31.3 billion), it now lies behind Italian rival Intesa Sanpaolo SpA. I repeat, as far as I can see Unicredit currently constitutes the greatest systemic risk to the eurozone banking system, and people somewhere ought to be thinking very carefully about just what the plan 'B' is going to be if all this goes horribly wrong.

Update: HVB Group Won't Need Funding Either

HVB Group, which is UniCredit's German banking unit, doesn't plan to tap Germany's government rescue fund for capital either, according to Theodor Weimer, head of global investment banking and chief executive officer designate for HVB in an interview yesterday.

"With a core capital ratio of 15 percent HVB doesn't need to ask the German bank rescue fund for capital, and we also won't need to sell toxic assets to the fund"... although...."Should German banks tap the fund for liquidity in an industry-wide effort, we would participate.''

HVB boosted its capital position last year by transfering its Bank Austria Creditanstalt AG business directly to UniCredit, and this month reported a third-quarter loss of 258 million euros ($325 million) as it wrote down assets. UniCredit acquired HVB in 2005 and now plans to eliminate 700 jobs in its investment-banking division (one-fifth of the unit's staff) which is now centralized at HVB.

``Investment banking doesn't need the manpower it had in the past and those who have adjusted to that early will emerge stronger from the crisis,'' Weimer said. ``Areas such as structured products, high-leverage and proprietary trading are completely different today.''

As Italy Enters It's Fourth Recession Since 2000, Who Will Bail-Out Unicredit?

2008-11-14T11:30:00.011+01:00

Italy, which is still the eurozone's third biggest economy, slipped into a recession in the third quarter. The Italian economy fell into what is now its fourth recession in less than a decade as gross domestic product shrank 0.5 percent from its level in the second quarter, when it contracted a revised 0.4 percent, the national statistics office said today. This is already Italy's worst recession since 1992, and there is evidently more and worse to come.

Italy effectively followed Germany, Europe's largest economy, in posting two consecutive quarters of contraction -- the technical definition of a recession. Spain contracted on the quarter, while France narrowly avoided recession by posting a slender 0.1% expansion after contracting in the second quarter.

From the third quarter of 2007 the economy contracted 0.9 percent, and this was the sharpest year on year quarterly decline in more than 15 years. ISTAT will provide a detailed breakdown of the GDP figures when it releases its final report on Dec. 12.

The IMF recently forecast that the Italian economy will shrink 0.1 percent this year and 0.2 percent next year, while Italy's employers organisation Confindustria are forecasting a 0.2 percent contraction this year. Making a rough, back of the envelope, calculation, if the economy once more contracts by 0.5 percent in the last quarter, we could be looking at a 0.4 percent contraction this year over 2007, and a year on year drop of around 0.9% again in the last quarter.

The real problem being raised here is not so much the recession itself, but the long term trend growth of the Italian economy in the light of the need to sustain a sovereign debt in the region of 104% of GDP and financing a rapidly ageing population. As can be seen in the long term growth chart below, Italy's growth rate has been steadily dwindling for some time now, and it is clear that this tendency is not going to be reversed any time in the near future.

Very Slender Bank Support Programme

Just how delicate all of this now is is highlighted by Italy's programme to help the banking system cope with the consequences of the global financial crisis, and deal with the impact of the economic unwinding which is currently taking place in Eastern Europe, which was finally approved by the European Commission earlier today (Friday).

The Commission said in a statement that the plan to offer guarantees for new banking debt and other aid was needed to remedy serious disturbances in the Italian economy.

"The Italian guarantee and swap scheme is an effective instrument for boosting market confidence and the commitments we have secured from the Italian authorities ensure that distortions of competition are kept to a minimum," EU Competition Commissioner Neelie Kroes said in a statement.

The Italian government says its conservative banking system has been hit less hard than others by the crisis, but even so the government has offered to swap up to 10 billion euros ($12.5 billion) in government bonds in temporary exchange for other forms of debt held by banks, and in any event it is by no means clear that the Italian banks will not be hit hard by what is now to come in the East of Europe.

This sum the Italian government has set aside compares with the Austrian government's 100 billion euro ($129 billion) banking package. Despite being a small country, Austria has a fairly large exposure to the East European banking system (equivalent on some estimates to 100% of Austrian GDP), but the exposure of Italian banks (and in particular Unicredit) is hardly negligible.

In reality, most of the capital that is being "readied up" in Austria is destined for use in underpining lending in CEE countries including Romania, Hungary, Bulgaria, Poland and the Baltics. As the Eastern Euopean euro-pegs break or the currencies slide, domestic households will have to be "eased of" CHF and euro denominated loans, and the subsidiaries of Austrian, Belgian, Swedish and Italian banks look set to have to eat large loses as a consequence.

"That this is about providing credit to Austrian companies is just a pretense," said Matthias Siller, who manages emerging market funds at Baring Asset Management. "This move is a clear commitment to eastern Europe......But this has nothing to do with charity. Those (Austrian) banks are system-relevant banks in central and Eastern Europe, and if they had to withdraw capital from there, this would set off a landslide," he said.

By tapping their home governments, those banks who have significant CEE exposure effectively lean on taxpayers in their home countries for refinancing countries with large current account imbalances, and large forex household debts. In other words Italian taxpayers are going to have to fund the losses Unicredit and other Italian banks will accumulate on their CEE lending just as the US Treasury is having to fund United States sub-prime loses. The difficulty is, however, that Italian taxpayers are already "in hock" up to their eyeballs, and if people aren't careful Italians could end up paying for some of the CEE loses with part of their future pension entitlements.

This is why this is no simple and ordinary "technical recession" and why the issue of where the money is going to come from to refloat Unicredit should the worst come to the worst, is the NUMBER ONE question facing the European bank bail out at this point in my humble opinion.

Industrial Output Falls Again In September, Making An Italian Recession A Certainty

2008-11-10T12:29:00.007+01:00

Italy probably entered a recession in the second half of 2008, International Monetary Fund and European Central Bank board member Mario Draghi indicated last month. After GDP contracted 0.3 percent in the second quarter, ``the most recent indicators confirm negative signs,'' Draghi said on Oct. 21. Europe's fourth- biggest economy will shrink 0.1 percent this year and 0.2 percent next year, the IMF said separately.

Italy's industrial production fell by the most in almost 10 years in September, confirming my impression that Europe's fourth-biggest economy is already in a recession. Output was down a seasonally adjusted 2.1 percent from August, the national statistics office said this morning (Monday).

Year on year, working day adjusted output fell 5.7 percent.

Italy's economy contracted 0.3 percent in the second quarter and is now in the midst of its fourth recession so far this century, or at least all the data we are seeing point that way. Most of the forecasts expect either stagnation (EU commission, Italian government) or contraction (Confindustria) in both 2008 and 2009. The pace of the decline is faster than most of the rest of Europe (excluding Spain), and the slump in sales has forced Italy's largest manufacturer, Fiat, to consider cutting the company's financial goals for the first time since the company returned to profitability in 2005.

Gross domestic product will stall for two years straight after expanding 1.5 percent last year, the European Union's executive arm said in a report published in Brussels today. Italy last stagnated in 2003, according to the national statistics office, Istat.

October Production Also Seems To Have Fallen

Italian manufacturing activity continued to contract - and at the fastest rate in at least 11 years - in October according to the latest Markit/ADACI PMI survey. The Markit Purchasing Managers Index fell to 39.7, its lowest since the series began in 1997, down from 44.4 in September. The Italian manufacturing PMI has now not been above the 50 mark separating growth from contraction since February and the latest data showed activity falling at an accelerating pace as demand shrank while jobs were shed at the fastest rate in the history of the survey. As we can see in the chart, the PMI has been giving a pretty reliable picture, and it looks virtually certain that, at least as far as manufacturing goes, the worst is yet to come.

Other recent indicators have also been far from encouraging, with October business confidence hit its lowest point since September 1993, when the economy seized up after Italy was rocketed out of the European Exchange Rate Mechanism a year earlier.

Falling Retail Sales

Euro-Zone retail sales fell again in October, with the index dropping from 46.2 in September to 44.3 in October, according to the latest retail PMI, the fifth consecutive month of sales contraction and one of the steepest declines recorded since the survey began five years ago. Sales fell in Germany, France and Italy as retailers reported the adverse effects of the global financial market turmoil, rising job market insecurity and stretched household budgets. Italy saw the steepest drop in retail sales of the three countries covered. The rate of decline accelerated sharply during the month with the month-on-month decline in the index the largest yet recorded by the Italian survey. (The index plunged from 42.8 to 34.8).

Confindustria recently said Italy was in "the darkest moment of the economic and financial crisis" and that government action was urgently needed to halt a recessionary spiral, noting in saying so that Italy's huge debt burden acted as a real brake on its options, and who am I to disagree. And is Italy actually in rcession? Well ISTAT are about to publish its first preliminary estimate for Italy's third-quarter GDP on November 14, so we will all soon know.

More Contraction In Italian Services As The Agony Goes On And On

2008-11-06T08:23:00.004+01:00

Italy's services sector contracted for the 11th consecutive month in October and new business levels and corporate morale hit record lows, according to the latest PMI survey published yesterday (Wednesday). The latest Markit/ADACI purchasing managers' index fell to 45.7, only just above July's 45.6, which was the lowest headline reading in the survey's near 11-year history.

"Italian service providers indicated that the entrenchment of the worldwide financial crisis, alongside marked falls in consumer demand, were the primary drivers of falling activity as they resulted in the survey record fall in new orders," Markit said.

The new orders index plunged well below the 50 divide between growth and contraction to 44.0 from September's 49.5, with transport and storage and postal and telecommunications companies the worst hit. Confidence among service providers hit the lowest level since the survey began, dropping to 54.5 from 63.9 in September.

Alongside the manufacturing PMI (see earlier post), which registered its lowest level in its 11-year history in October, and the launching of the bank support plan as domestic credit grinds to a halt (see yesterday) the data underline the daunting task facing Silvio Berlusconi's government which is still considering how to try to revive the economy without adding to the country's massive public debt.

The services PMI survey showed input price inflation drpooed back to a 13-month low, even if at 60.7 it still remained above the long-term average of 59.7. The tough business climate, however, prevented companies from passing their rising costs on to customers and prices charged index fell in October to 49.1, adding to evidence of a drop in inflationary pressures that could calm the troubled nerves over at the European Central Bank as they move in with the first of what are expected to be a series of aggressive rate cuts when they meet this afternoon.

Global Services Contract

Outside Italy, service sector activity in the euro zone hit a fresh decade low in October. The final Markit Eurozone Purchasing Managers' Index slumped to 45.8 the lowest in the survey's 10-year history. The fact that the final reading is significantly below the flash estimate (of only one week ago) and sharply down from September's 48.4 would seem to indicate that the contraction in services is accelerating rapidly at this point across the eurozone.

Global services activity also slumped to its lowest level since 2001 in October, dragged down by the especially weak European service sector, according to the Global Services Business Activity Index, produced by JP Morgan, which plummeted to 44.2 in October from 50.2 in September.

That was the second lowest result in the survey's 10-year history, behind only the month after the September 2001 attacks in the United States.

Itay's Government Set To Inject 30 Billion Euros Into Banks

2008-11-05T10:35:00.004+01:00

According to press reports today the Italian government is preparing to provide a capital injection of up to €30bn ($39bn) for Italy's troubled banking sector. Details of the plan are expected over the next few days, but the main objective seems to be an attempt to ensure the banks have sufficient liquidity to enable them to keep lending to Italian companies and keep an economy which appears to be in danger of seizing up turning over. This news follows weeks insisting from Rome that Itay's banking sector did not need to be recapitalised.

The Italian government is still very reluctant to officially disclose the value of the package, since clearly given the level of Italian public debt this is a very sensitive issue. Berlusconi basically stone walled reporters at a Milan press conference earlier today (Wednesday). He limited himself to stating that the government intended to pass the measures by decree, which is a fast-track way of enacting legislation. He added that the Italian government intended to guarantee some bank debt and buy preferred stock in banks if necessary.

Italian companies have been complaining quite loudly in recent days that the banks are becoming increasingly reluctant to lend or to roll over debts, and this, in an economy where bank loans are the main and often the only form of financing for all except the very biggest companies, is a big problem when it comes to keeping business moving. There is growing evidence - in the form of the slowdown in manufacturing activity and the drop in retail sales - that this is not mere winging, and that there are significant difficulties in obtaining credit. What this means is that the Italian economy is now possibly heading not for a couple of years of zero or slightly negative growth, but for a severe recession. Economists at Capital Economics forecast this week that the Italian economy would shrink by 1.5 per cent in 2009. This seems to be in the right ballpark if we take the data we have been seeing recently seriously, and I personally am revising downwards my own expectations - which weren't exactly high before this current phase set in.

Details of what the government is planning have not been finalised, and talks were continuing among the banks, the Bank of Italy, and the relevant ministries, the bankers said. But the plan may well be unveiled ahead of a meeting of European Union leaders on Friday.

Economic development minister Claudio Scajola has also indicated that the government is in the process of creating a €650m fund to guarantee lending to small and medium-sized Italian enterprises hit by the credit squeeze.

The Italian government approved a decree on rescuing banks on October 9 but the government has still to disclose how it plans to implement it. Unlike other European countries, Italy has not poured any cash into its banks and has not created a special fund to help them. But it has offered to inject capital or underwrite debt if any bank requests it. But a new entity - called the Corporate Financing Fund - has been created and its remit will be to keep open a channel of financing to companies in an attempt to avoid that "in the context of a recession, banks restrict lending and choke companies,'' in the words of Finance Minister Giulio Tremonti.

The government may use tools like perpetual bonds, which pay interest indefinitely, to help finance the plan, according to Vittorio Grilli, director general of the Italian Treasury. The funds for Italian companies will be part of a broader package of measures aimed at helping banks raise their capital levels to make it easier for them to sustain lending.

Government Borrowing Getting More and More Difficult

The yield spread between German 10 year bunds and some other eurozone sovereign debt of equivalent maturity is now the widest since 1997, and investors are demonstrating a preference for only the most liquid of government bond markets as implications of the scale of the European bank bailout begins to dawn on the financial markets. The gap between bunds and their Italian counterparts widened to 127 basis points yesterday, while difference with Spanish 10-year debt was 69 basis points as news broke that the country's economy contracted in the third quarter for only the first time since 1993.

Also we learnt today that credit-default swap traders were prepared to bet more the default risk for Italian and Spanish government debt and Deutsche Bank than on any other comparable risk wager, according to a Depository Trust & Clearing Corp. report that gives the broadest data yet on the credit-default swap market.

A total $33.6 trillion of transactions are currently outstanding on governments, companies and asset-backed securities worldwide, based on gross numbers, the DTCC said in a report released yesterday (Tuesday). After canceling out overlapping trades, investors have taken out a net $22.7 billion of contracts based on Italy's debt, $16.7 billion against Spain and $12.5 billion on Deutsche Bank of Frankfurt, the report shows.

The DTCC, which operates a central registry of credit swaps trades, released the data for the first time as the industry steps up efforts to counter critics among U.S. lawmakers and regulators who blamed the lack of data for exacerbating the financial panic.

Investors have focused wagers on debt of industries and countries that may be most affected by a credit crisis which is now entering its 15th month. The Spanish economy is headed toward its first recession in 15 years amid a slump in its housing market and banking and finance shares have dropped as the credit seizure starts to caused builders and property devopment companies to collapse.

Credit-default swaps on Italy were quoted at 108 basis points yesterday after reaching a record 138 basis points on Oct. 24, CMA Datavision prices on 10-year contracts show. The contracts have more than doubled since August. Yesterday's trading represents a cost of $108,000 a year to protect $10 million of debt for 10 years. Contracts on Spain climbed to 112 basis points on Oct. 24, from about 47 basis points at the start of September. They have since dropped back to 79 basis points.

Turkey, Italy, Brazil, Russia, GMAC LLC, and Merrill Lynch & Co. had the biggest gross amount of contracts outstanding on their debt as of Oct. 31. Turkey alone had $188.6 billion of default swaps written against its debt. The gross amount however doesn't take into account offsetting trades. After netting the trades, there were, for example, only $7.6 billion outstanding on Turkey's debt.

Italian Manufacturing Contracts Sharply Again In October

2008-11-04T08:50:00.009+01:00

Italian manufacturing activity contracted at the fastest rate in at least 11 years in October as the global financial crisis continued to hit the real economy, according to the latest Markit/ADACI PMI survey out yesterday (Monday). The Markit Purchasing Managers Index fell to 39.7, its lowest since the series began in 1997, down from 44.4 in September. The Italian manufacturing PMI has now not been above the 50 mark separating growth from contraction since February and the latest data showed activity falling at an accelerating pace as demand shrank while jobs were shed at the fastest rate in the history of the survey.

Italian new car sales were down 18.89 percent year-on-year in October, according to data earlier this week from the transport ministry, Fiat sales were down 13.1 percent, and their market share stood at 32.83 percent.

Other recent indicators have also been far from encouraging, with October business confidence hit its lowest point since September 1993, when the economy seized up after Italy was rocketed out of the European Exchange Rate Mechanism a year earlier.

Last week Confindustria said Italy was in "the darkest moment of the economic and financial crisis" where government action was needed to halt a recessionary spiral, but it also noted Italy's huge debt burden limited its options.

Fastest Rate Of PMI Deline Yet Recorded

The latest Markit/ADACI data point to a very sharp October deterioration in operating conditions in the Italian manufacturing sector. The headline Purchasing Managers' Index (PMI) , which is designed to give a single-figure snapshot of operating conditions in the manufacturing economy, posted 39.7 in October, falling from 44.4 in September, the fastest deterioration in operating conditions in over eleven-and-a-half years of data collection. Output, new orders, employment, backlogs of work and purchasing activity all declined at series record rates.

Markit reported that survey respondents attributed the sharpness of the decline to the deepening of the financial crisis, which had reduced demand from both domestic and overseas markets. Total new orders contracted at a series record pace, while orders from abroad fell at their strongest rate since October 2001.

Record declines in production volumes and incoming new business inevitably fed through to employment levels in the manufacturing sector. Firms reported in many cases that outgoing staff had not been replaced, in line with cost considerations. October marked the fastest rate of job-shedding in the history of the survey.

Respondents also reported that price pressures eased considerably during October, with input price inflation slowing to a fractional rate. Firms reported that a dramatic decline in the global prices for raw materials had been the primary driver of rapid price disinflation they were seeing. However, a stronger US dollar was reported in some cases to have raised costs. The easing of input cost inflation, alongside weakening demand increasing competition, resulted in Italian manufacturers reducing factory gate prices for the first time since August 2005.

Firms markedly reduced purchasing activity during October, with panellists indicating that protracted falls in demand and output had reduced the requirement for input goods. A record decline in the quantity of purchases bought reduced pressures on suppliers, resulting in a sharp improvement in delivery times. Stocks of pre-production inventories also contracted considerably, as firms delay purchases at a time of heightened uncertainty.

At 32.0, the seasonally adjusted New Orders Index signalled the sharpest decline in incoming new business to the Italian manufacturing sector in the history of the survey. Moreover, the index fell considerably from 40.4 reported in September. Over 53% of respondents recorded a fall in new order books, reporting that the world wide economic downturn had strongly affected domestic demand and that the financial crisis had forced clients to hold off purchasing activity.

New orders received from abroad also plunged during October, as signalled by the seasonally adjusted New Export Orders Index posting 38.5, falling substantially from 44.5 in September. A sharper decline in new orders has only previously been recorded once before, in October 2001 (the aftermath of the US terrorist attacks). Panellists indicated that the world wide financial crisis had been the main driver, and that demand from key export markets including eastern Europe and the US, had been notably affected.

Staffing levels in the Italian manufacturing sector were cut at the fastest rate in the survey history during October. At 45.5, the seasonally adjusted Employment Index fell from 48.7 recorded in September, to indicate a marked rate of job shedding. Almost 13% of panel members indicated that employment levels had been cut, reporting that significant declines in demand (from both domestic and overseas markets) was the primary driver. A number of firms also indicated that outgoing staff had not been replaced in order to reduce costs.

At 49.1, the seasonally adjusted Output Prices Index fell from 52.2 in September to signal a decline in factory gate prices for the first time since August 2005. The reading was well below both the twelve-month and long-run series averages of 55.0 and 52.9 respectively. Panellists broadly attributed the cut in tariffs to falling demand leading to increased levels of competition, alongside the abatement of raw materials costs over the month reducing the pressure to raise charges.

Input price inflation eased to a thirty-nine month low in October and, at 50.2, the seasonally adjusted Input Prices Index signalled only a marginal rise in costs. Highlighting the sideways trend, almost 60% of panellists indicated that input costs had remained constant during October. Those panel members facing an increase in costs cited the weak euro/dollar exchange rate as the primary driver. Firms reporting a decline in input costs indicated that a marked fall in the cost of raw materials over the month had been the main contributing factor.

The JP Morgan Global Manufacturing Index Plummets Too

The October contraction in Italy, while undoubtedly revealing in its own right, in fact forms part of a much more general global pattern. Indeed the latest JP Morgan Global PMI report really does makes for quite depressing reading.

The world manufacturing sector suffered its sharpest contraction in survey history during October, as the ongoing retrenchment of global demand and further deepening of the credit market crisis negatively impacted on the trends in output, new orders and employment. The JPMorgan Global Manufacturing PMI posted 41.0, its lowest reading since data were first compiled in January 1998 and a level below the no-change mark of 50.0 for the fifth month in a row.

Output, total new orders and new export orders all contracted at the fastest rates in the survey history in October. With the exception of India, which again bucked the global trend, all of the national manufacturing surveys posted declines in output and new orders. The impact of the downshift in global market conditions also had a far-reaching effect on international trade volumes. Although new export orders fell at a slower rate than total new business, all of the national manufacturing sectors covered by the survey (including India) saw a reduction in new export orders.

"October manufacturing PMI data reinforce the stark retrenchment that the sector is currently facing, with production, total new business and new export orders all falling at record rates. The latest Output Index reading is consistent with a fall in global IP of almost 8%. The only positive from the surveys was a decline in input prices for the first time since August 2003."
David Hensley, Director of Global Economics Coordination at JPMorgan

Economies across the Eurozone are being affected. The French manufacturing purchasing managers index was revised down to a series low 40.6 in October, down from both the 'flash' estimate of 40.8 and September's 43.0 figure, Markit Economics said in a press release issued on Monday.

Disaggregating the figures, the output component fell to an all-time low of 37.8 from September's 41.7 level, while new orders slipped all the way to a series low of 34.9 for the month, down 2.6 points from September's 37.5 level. Purchase quantities and new export orders also saw some new record lows in October, falling to 33.7 and 38.5 respectively.

Germany's manufacturing sector contracted in October at the fastest pace in seven years as incoming orders and output experienced their sharpest declines in more than 12 years. The headline index in the Markit Purchasing Managers Index for what is Europe's biggest economy fell in October to 42.9 from 47.4 the previous month, well below the 50 mark that separates growth from contraction.

Spain's manufacturing sector continued to shrink at a record pace in October, with both output and new orders contracting and employers shedding jobs at a near record pace, according to the latest Markit Economics Purchasing Managers Index published yesterday (Monday). The Markit PMI for Spain dropped to 34.6 in October, the lowest reading registered by any eurozone economy since the series began in February 1998 and down from the already rapid 38.3 point contraction in September. On the PMI system any figure below 50.0 shows contraction while figures over 50.0 show growth. As we can see, according to this indicator Spanish manufacturing has now been weakening steadily since the start of 2006.

Eastern Europe

Hungary's manufacturing industry contracted sharply in October, with the PMI dropping 5.2 points to hit 44.7 in October - a historic low, and 0.8 points below the previous worst reading registered in October 1998, according to the latest data from the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM).

In Poland the ABN Amro Purchasing Managers Index fell for the sixth month running to 43.7 (down from September's 44.9) a record low and well below the neutral reading of 50, according to Markit Economics yesterday. In the Czech Republic, manufacturing output contracted for the seventh month in a row, and the index hit an all-time low of 41.2, just above the revised euro zone figure of 41.1. As the Eurozone itself contracts, these economies which are heavily dependent for exports to the zone will be buffeted, especially now that forex loans for their domestic housing markets have all but dried up.

US Manufacturing

The US manufacturing PMI dropped back to 38.9 in October from 43.5 in September, indicating a significantly faster rate of decline in manufacturing when comparing October to September. It appears that US manufacturing is experiencing significant demand destruction as a result of recent events. October's reading is the lowest level for the US PMI since September 1982 when it registered 38.8 percent. On the other hand inflationary pressures are evaporating rapidly, and the Prices Index fell to 37, the lowest level since December 2001 when it registered 33.2 percent. Export orders also contracted for the first time in 70 months.

The BRICs

China's PMI dropped to lows not previously seen in October, confirming that the economy of the so-called factory of the world is now decelerating along with everyone else. Two international surveys measuring the PMI independently corroborated the evidence of a cooling Chinese industrial economy.

According to a survey complied by securities firm CLSA, China's PMI fell to 45.2 in October, its third consecutive drop, from 47.7 in September, as new orders and exports, as well as pricing power, were squeezed by the global financial crisis.

"The very sharp fall in the October PMI confirms that China is more integrated into the global economy than ever. Chinese manufacturers are seeing their order books cut, both at home and abroad, as the world economy falls into recession," said Eric Fishwick, CLSA's head of economic research, in a report released Monday. "Costs are falling but so are output prices. The coming 12 months will be difficult ones for manufacturers, China included."

The government-backed China Federation of Logistics purchasing managers' index - published on 1 November - also showed a strong contraction, falling to 44.6 in October, the lowest level since the data began in 2005, from 51.2 in September

Russian manufacturing contracted in October at the slowest pace in over two and a half years as the global financial crisis cut demand, according to the latest reading on VTB Bank Europe's Purchasing Managers' Index, which fell to 46.4 from 49.8 in September. This was the third consecutive month in which Russian industry has been contracting.

Business conditions in the Brazilian manufacturing worsened in October for the first time since June 2006. The headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) posted 45.7, down from 50.4 in September, pointing to a sharp contraction -the fastest in the survey history in fact. The PMI was driven down by accelerated declines in output and new orders, as well as falls in employment and stocks of purchases.

Even in India the seasonally adjusted ABN Amro India Manufacturing Purchasing Managers’ Index dropped steeply in October, falling to a record low of 52.2, down from a reading of 57.3 in September suggesting another sharp deceleration in growth, even if Indian industry managed to keep expanding. The biggest fall was in the new orders sub-index, which dropped to 54.4 in October from 62.6 in September. Perhaps the saving grace in the Indian survey is that most firms said demand remained strong in domestic markets, while it had been international orders which had waned. This can also be seen from the new export orders sub-index, which contracted to 49.7 for the first time in the history of the series. That fits in with the latest data showing that Indian year on year export growth slowed to 10.4% in September. Thus the Indian expansion is still hanging on in there, by its fingernails, but it is hanging on in.