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Friday, August 17, 2007

Sarkozy Gets His Respone: A Latvian Sovereign Debt Downgrade

Yesterday I wrote what was in the event a reflective, and possibly excessively guarded, post on the issue of the proposed EU Commission investigation of the debt rating agencies like Standard and Poor's and Moody's. (But then again, these are troubled times, so perhaps guarded comments are in order). Anyway the response from the ratings agencies wasn't long in coming. Yesterday Moody's warned of a potential LTCM-scale hedge fund collapse (hardly likely to pour soothing oil on troubled waters that) and today Fitch has cut Latvia's country rating to BBB+. None of this is going to help stabilise things, but I really can't see what else people expect the ratings agencies to do if you start to pile the pressure on them.

So why am I pointing the finger at Nicolas Sarkozy? Well, according to the Financial Times:

In a letter to Angela Merkel, the German chancellor and acting president of the group of eight industrialised nations, which includes the G7, Mr Sarkozy highlighted his concerns over the weaknesses of the international financial system revealed by the present crisis.

He called for G7 finance ministers to draw up proposals for their meeting in Washington in October to address transparency and risk awareness among market participants and regulators.

He said the G7 should join the European Commission in investigating the role played by credit ratings agencies in the crisis, and said that bank involvement in credit markets should also be addressed.

Now obviously, in general terms, there may be little to disagree with here. A nice theoretical discussion of transparency, and the role of the ratings agencies (which could also be extended to the role of the EU Commission and the ECB when it comes to the tricky question of the sovereign debt ratings of some delicate EU member states) may well be in order. But, I ask you, is now, precisely now, the moment to be airing all this. Isn't the number one priority for everyone right now to settle the markets down, and to try and pass through this storm without any excess damage?

But no, we need a scapegoat, and the scapegoat it would seem is to be the ratings agencies, forgetting conveniently in the process that only last week they were being regarded as the last firewall of collective defence.

So what do you expect, the agencies themselves hit back, at least to cover themselves. Yesterday it was Chris Mahoney, vice chairman of Moody's who responded in kind:

Moody's Investors Service fueled concern that the global credit crisis is worsening by speculating that a hedge fund collapse on the same scale as Long-Term Capital Management LP in 1998 is possible.

Hedge funds face potential losses on collateralized debt obligations, securities packaging bonds, loans and other assets, Chris Mahoney, vice chairman of Moody's, said on a conference call today. The funds are unable to agree on prices to sell riskier assets, causing the market to seize up, Mahoney said.

Then today it was the turn of Fitch:

Latvia's long-term sovereign rating was cut to BBB+ from A- by Fitch Rating Service as government plans to keep the economy from overheating are ``insufficient.''

``The Latvian economy is severely overheating and Fitch considers the policy reaction of the government to be insufficient to restore the economy to a sustainable growth path,'' David Heslam, director of Fitch's Emerging Europe sovereigns groups said in an e-mailed statement.

Fitch left the outlook at stable. The Baltic country had its credit rating cut by Standard & Poor's in May to BBB+ on concerns the country's growth was accelerating out of control, resulting in a so-called ``hard landing.''

Now this decision by Fitch also begins to put the ECB in an interesting situation. Let us go back to November 2005, and the ECB decison to only accept bonds with at least a single A- rating from one or more of the main rating agencies as collateral in its financial market activities (and the original article here).

Well technically Latvia still has an A2 rating from Moody's, and this is equivalent to an A- (as has Italy in the case of Moody's), so the ECB will in theory continue to accept Latvian paper, but at this pace it would only seem to be a matter of time before Moody's downgrade too, especially with Sarkozy loading on the pressure. This will, apart from making it much more difficult for the Latvian government to raise credit, effectively take away the guarantee which underpins the present structural distortion in the Latvian economy, put even more distance between Latvia and membership of the euro, and complicate the task of the Latvian government in trying to steer the economy forward. Bottom line: is all of this a good idea. Answer: what you ask for is what you get, so my advice in future is to think first before opening your mouth.

The principal point I want to make here is that while in the normal course of events such downgrades - or the threat of them - may serve a useful purpose by putting pressure on governments to change course, in the current climate these very same downgrades may only serve to provoke the very situation which they are intended to avert, and that is the danger now. Let us remember what Buttonwood wisely, and possibly presciently, said:

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.

Is Estonia Heading For A Soft Landing?

Regular readers will have noticed that Claus Vistesen and I have been looking particularly closely at the Baltic economies of late (or here, or the dedicated weblog I have opened on Latvia). They seem to be experiencing a series of structural difficulties which make them particularly interesting for economists at this point in time. They also could find themselves right in the eye of the storm if the current bout of market nervousness ends in tears.

With all of this in mind I couldn't help noticing, earlier in the week, a number of reports in the press suggesting that the recent (2nd quarter 2007) decline in the Estonian growth rate was an indication of the fact that a "soft landing" was now to be expected there. This article from Bloomberg more or less typical of the reception with which the data release was greeted:

Estonia's economy grew at its slowest pace in two and a half years in the second quarter, as manufacturing output ebbed and oil shipments from Russia declined.

The $15.1 billion economy grew an annual 7.3 percent, compared with 9.8 percent in the first three months of the year, the Tallinn-based statistics office said on its Web site today. ``The number takes out the worst fears about overheating,'' said Mika Erkkila, a senior analyst with Nordea Bank in Helsinki in an e-mailed comment.``However, 7.3 percent is still above the long-run sustainable rate and hence it will still take a quarter or two with further slowing growth before we can conclude that we are out of the woods.''

The central bank said the data was in line with its previous forecasts the economy will make a ``soft landing.'' Trade data also indicated the current-account deficit has stopped growing, it said in an e-mailed statement.

The finance ministry said growth should slow further in the third quarter, citing weaker business and consumer confidence. The slowdown in the second quarter was more than expected, but still ``welcome'' after prolonged growth above potential, the ministry said in an e-mailed statement.

Now I was intrigued by all of this since in the first place I don't think any decision on hard and soft landings is something you can take on the basis of a simple quarterly GDP reading (leaving aside for the present time the question of what exactly we mean by hard and soft landings in this context, a topic which I have attempted to address in this post), and in the second place I don't think you can even begin to address the issue in an emerging markets context (and yes, the Eastern Europe EU 10 are in the sense that counts here still "emerging markets")without taking some account of the final landing the financial markets will have when the current bout of turmoil ends. But still, as I say, I am intrigued by the way people can make such assertions, and what they think the grounds for making them are. So I started to dig a little deeper. And here is what I found.

In the first place it may be useful to take the arguments as they are being presented one at a time, since the way people justify their opinions is important, and I do think there is some confusion abroad about is being talked about here.

What is being asserted is:

1) That the year on year growth as measured by quarters has slowed in Estonia (this is certainly true, it has).

2) That the growth rate needs to slow further to "get out of the woods".

3) The Finance Ministry consider the slowdown greater than expected, but still "welcome".

4) The data is consistent with the possibility of Estonia having a soft landing.

Points (2) to (4) seem to me to be misleading, and now I'll try and explain why. (Incidentally, here is the original Estonia statistical office release which lies behind the report. It is worth noting that what we have here is only a "flash release", the complete initial data will only be available in September, together with what promises to be a complete overhaul of recent Estonian GDP data, so we well may be in for some surprises yet awhile, but still, if we want to decide whether or not we face a possible hard or soft landing at this point we have to work with the data we have, such as it is).

One of the difficulties about measuring economic growth is that you are never sure just which numbers to look at. You could look at GDP evolution (by quarters, lets stay with quarters here) in straight current money terms, a process which for some strange reason we economists refer to as viewing the data in "nominal" terms. So lets start here, and to do this here's a chart for Estonian GDP at current prices and non-seasonally adjusted since the start of 2006.

Well this chart is reasonably easy to interpret, and there is no big mystery here, in the sense that it is clear that the Estonian economy is, and has been, growing. So, lets dig-down a little deeper: here's a chart for Estonian GDP at current prices and non-seasonally adjusted since 2000.

Now the interesting thing to notice, is that in these "raw", non-adjusted, figures, you can see a clear decline in GDP in Q1 each year when compared with Q4 in the previous one. So the annual data have a rather irregular flavor, and this will be important when we get to what is happening in 2007.

Ok, so now let's look at the data from 2005 on a seasonally adjusted and constant (2000) price basis, ie what we economists call in "real GDP growth" terms.

Here what we can see here is that while the Estonian economy has been growing, the rate of growth has been slowing for some quarters now. This slowing becomes even clearer if we look at the quarterly growth in real terms.

Here it becomes apparent that the Estonian economy probably peaked somewhere between the 3rd quarter of 2005 and the 1st quarter of 2006. But what stands out even more is what happened in Q2 2007 (with a quarterly growth rate of only 0.2% according to my calculations). This is almost - in Baltic economy terms - to grind to a halt. Indeed since the Q1 2007 figures are seasonally corrected, and it is not clear to what extent the "correction" being used is valid during such a sudden slowdown, the deceleration may be more equally distributed over the two quarters than it seems, but still, the drop is real and evident enough.

The issue is however compounded by one additional factor, which only adds to our difficulties: the bronze soldier factor. Back in April Estonian authorities exhumed the remains of 12 Soviet soldiers and moved the associated bronze statue to a military cemetery on the outskirts of Tallinn. This move provoked significant protests in Tallinn and other Estonian cities, disturbances which lead to the detention of over 1,000 people, to dozens injured and to the death of one Russian national.

Predictably the Russians have responded in kind, by taking administrative economic measures against Estonia.

Tiit Vahi, Estonia's former prime minister and owner of the Silmet plant, is quoted in the Estonian press as saying the downturn was predictable, given that the economy was bound to be negatively affected by any worsening in relations with Russia.

"Russia has used administrative measures, scaling down rail service and limiting exports to Estonia and imports from Estonia," he is quoted as saying.

This view is also shared by Tiit Tammsaar, head of Baltic Panel Group, who said his company, which produces plywood, has been experiencing a shortage of raw materials from Russia.

The state-controlled railway Eesti Raudtee has also indicated that the volume of rail shipments fell 35% in July, year-on-year, to 2.5 million metric tons, while the volume of oil shipments in July fell 34%, year-on-year, to 1.55 million metric tons, and coal shipments declined 60% in July, year-on-year.

As a result of this Eesti Raudtee has had to lay off 200 employees due to a fall in the volume of freight traffic to Russia.

So what can we conclude from all this? Well in the first place the obvious point would be that it is very important when you enter a critical economic period as Estonia has, not to shoot yourself in the foot. But then this is exactly what Estonia seems to have done.

Clearly the dispute with Russia has produced a dramatic screech of the brakes in Estonia. Does this mean that a hard landing is now inevitable? Well, not necessarily, since to know the answer to this question we need to know what happens next in the financial markets, but what we can say is that the possibility of a hard landing has risen considerably, while what we most definitely can't say is that this slowdown is positive (or "welcome" even, given its scale) or that it provides evidence of a soft landing. Au contraire and caveat emptor.

Thursday, August 16, 2007

Ratings Agencies and Sovereign Debt

The Financial Times this morning informs us that the European Commission seems less than pleased with the recent performance of the ratings agencies:

The European Commission is to investigate credit ratings agencies amid growing dismay over their slow response to the subprime mortgage crisis.

Officials in Brussels, and many other critics, believe the ratings agencies failed to act quickly enough to warn investors about the risks of investing in securities backed by US subprime mortgages – the sector whose troubles triggered the recent global market volatility.

In the United States we are also informed that Barney Frank, Democrat chairman of the House financial services committee, plans to hold hearings on the agencies’ performance next month. I just wonder, especially from a European perspective, if this isn't a problem - and a response from the Commission - that will come back and haunt us all.

Not that the agencies are themselves entirely free of blame in the present situation, obviously there are issues which arise, but my point would be that these were all evident before the current crisis came upon us, so maybe we could have an EU Commission and US House of Representatives investigation into why the people who are being so vociferous now were so silent then.

Obviously there are issues of professional coherency involved here since the agencies are, of course, businesses in their own right, and they are not simply giving an opinion. They are in fact consultants to a lot of the companies that have issued the sort of debt instruments that are now under the hammer. They have rated these companies, and that's one of the ways they make their money.

Equally obviously this will all need to be scrutinized after the storm settles again, but since almost everyone knew - or should have known - what was going on, it is rather unjust, and unnecessarily destabilising, to simply point the finger at the agencies themselves. It is important at some level that their credibility be maintained.

The reason I say this is because the real problem I am thinking about in writing all this is not so much the corporate or hedge fund debt one, but looming sovereign debt and emerging market risk ones.

Essentially we have two major economic players - Italy and Japan - with levels of debt to GDP which are way beyond what might be considered prudent, especially in the light of the ongoing weaknesses in their economies, and the dynamics which may be associated with the rapid ageing of their populations. At the same time within the frontiers of the EU we have a collection of countries - effectively the old Eastern bloc countries, the EU10 - which could be classified as "emerging economies". Among this latter group there are several - Latvia, Lithuania, Estonia, Hungary - who have recently been having "issues" with the ratings agencies.

Effectively the European problem arises from weaknesses in the EU's own institutional structure - the ECB, the Commission - and in the political and monetary framework within which these institutions work. We have had a process - known as the Stability and Growth Pact - which has signally failed to work to contain the debt dynamics of some significant eurozone participant economies - Italy and Greece would immediately come to mind here - and since the ECB is effectively seen as offering some kind of guarantee, the problem has to some extent been allowed to grow unchecked despite persistent efforts from the Commission to browbeat the governments concerned.

So, and I think more out of frustration than clear thinking, the ratings agencies were brought into the act as "guarantors of last resort" with the ECB declaring back in 2005 that they would not in the future accept government paper (bonds) from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies.

Now this is to put one hell of a lot of responsibility into the laps of these same assessment agencies, since who would really like to be the person with responsibility for pulling the plug on Italy's sovereign debt, or for that matter for deciding that Latvia is rapidly headed for a hard landing and the euro-Lat peg is going to break?

In general terms the "sobriety" of these institutions, coupled with the fact that many of the states and affiliates involved are important clients at one level or another, would normally be thought to operate as an effective brake on any such "upping the anti" type process. But if you then start chiding and castigating these very same people for not being forceful and vigilant enough, what sort of results result do you really expect next time they have to carry out a review on - say - Italy's creditworthiness, or the steps Estonia is taking to correct its imbalances and overheating issue. This becomes doubly important since the most recent data from Italy suggest that she will have difficulty again in 2007 meeting the criteria for the debt dynamic that were agreed upon last year.

The difficulty is, as Buttonwood recently observed in the Economist, that the response of these agencies to developing problems is often neither linear nor consistent. During the "good times" they tend to understate the problems, whilst during the bad ones they may well err on the side of overstating them.

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.

The sub prime situation is in fact a good "case in point" example of this process at work. And after the agencies themselves admit the problems were worse than previously anticipated, then the markets, predictably, also over-react. So the question I am asking is, would we all now really like to see this situation replicated in the case of the Italian debt problem, or the Baltic overheating issue? Would we, or the EU Commission, be happy with the outcome?

I think in this kind of area it is better not to tempt fate, or call on others to do what you are not prepared to do yourself. In the event that the Italian government is one day forced to default on its sovereign debt, will we be holding the European Commission itself responsible in the way that they would now try to point the finger at Standard and Poor's or Moody's? The root of the problem here is that the EU itself needs to be able to make accurate and clear assessments of the underlying issues involved on its own account, and to develop the capacity to face up to difficult decisions, take them, and then make them stick, rather than simply fudging everything in an ongoing process of political "deals" and horse trading. Nor is it a solution, when the going gets really tough, to outsource responsibility to agencies which really are neither designed for, or adequate to, the task in hand.

Bloomberg also has a timely piece on the background to the whole constant proportion debt obligations situation. And note this:

The legacy built by John Moody and Henry Varnum Poor a century or more ago is being tarnished by losses on securities linked to everything from subprime mortgages that the firms failed to downgrade before it was too late to high-yield, high- risk loans. Bonds backed by mortgages to people with poor credit fell by more than 50 cents on the dollar in June before the companies started to slash their ratings.

Ratings firms ``used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,'' said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. ``But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.''

I think this is the point. Too much importance and pressure has been placed on these agencies, can they really be blamed to such an extent when it turns out they can't hack it? We need to think carefully about the sovereign debt issue in the context of steadily ageing populations. Other mechanisms have to be found.

Tuesday, August 14, 2007

Italian GDP Slows

Economic growth in Italy slowed even further in the second quarter of 2007, according to provisional figures released on Friday by the National Statistics Institute ISTAT. In the April-June quarter gross domestic product increased by only 0.1 per cent, compared with the first quarter of 2007, when GDP grew by 0.3 per cent (see chart below). This is the slowest growth in the last 18 months. Projected growth for 2007 has so far declined from 2.3 per cent based on the first quarter, to only 1.8 per cent at present. This number, apart from being far below the current European Union average of 2.6%, now looks like it may well need further downward revision.

The projections are now also significantly below the estimated 2 per cent growth for 2007 which the government used as a basis for its economic and financial planning document in June. The blueprint envisaged cutting budget deficits, as well as a gradual reduction of the national debt from the current 107 per cent of GDP to 100 per cent of GDP by 2010. Less growth will inevitably result in a smaller increase in revenue, and run the risk of yet more problems with the debt rating agencies.

As the Financial Times says:

If this trend continues, it could create serious difficulties for the centre-left coalition led by Romano Prodi, the prime minister, for whom economic rigour, growth and a reduction of the huge national debt are primary goals.

In general the picture has been becoming reasonably clear from the industrial output numbers we have been seeing, the retail sales data, as well as the consumer confidence readings.

If we look at the chart below which shows year-on-year GDP growth rates by quarter, then it is really starting to look like this cycle may have peaked in the last quarter of 2007.

And if we look at the evolution of Italian GDP growth rates it is clear that the situation is not a new one, average growth rates for the Italian economy have been trending down for the last couple of decades, and it is a hopeless form of wishful thinking to imagine that things will change just like that. If the author of this blog is right this whole process is associated with the steading ageing of Italian society, and if it is then the issue will just not go away, and there will be some explaining to be done to the ratings agencies about just why it was thought to be convenient only two weeks ago, to slow down the implementation of the retirement age reform.

Monday, August 13, 2007

Inflation Creeps Up in China

Inflation in China is ticking up (as we can see from the chart below). In fact China’s inflation rate hit a ten-year high of 5.6 per cent in July, producing a spike which has raised expectations about further tightening measures as well as increased concerns there might be an eventual knock-on impact on the real economy.

On the other hand, as the Financial Times notes:

The rise in the consumer price index was mainly the result of higher food prices, a result of a shortage of staple meats, especially pork, following an illness which killed millions of pigs late last year, and higher feed costs.

So I think we need to be very careful before coming to any over hasty conclusions. If we look at the producer price situation for manufactured goods (see chart below), we find that, in July, the Producers’ Price Index (PPI) for manufactured goods up by 2.4 percent from the same month last year. At the same time the purchasing prices for raw material, fuels and power rose by 3.6 percent. So while there is cost pressure from inputs, there is no sign of these producing sustained inflationary upward pressure on producer prices yet.

So while the People’s Bank of China has been sounding more and more hawkish about inflation of late, and especially in its last quarterly monetary report, we still need to wait and see to what extent this passes through to monetary tightening, and even in the event that it does, to what extent - given the overarching liquidity background - to what extent this passes through to impacts on the real economy.

I cannot help feeling that what is going on in the financial markets and the international banking sector right now will be much more significant for determining the future Chinese growth path.