February EU Commission Interim Forecast

The European Commission released a new interim forecast for the EU economies yesterday. Of particular note was the fact that the forecast significantly reduces the growth forecasts at the same time as sharply raising its inflation estimate The Commission said it was concerned that expectations of steadily rising prices were becoming entrenched in the 15-nation area.

My own opinion is that the current forecasts are far more realistic than than those issued in last November's autumn review. The outlook for growth in the eurozone as a whole for 2008 has been cut to 1.8 per cent from an earlier 2.2 per cent, but of more significance perhaps are the individual country estimates. Italy, which has been the eurozone’s slowest growing economy for the past 15 years, once again comes in at the bottom of the pile, with the Commission halving its growth forecast for this year to a mere 0.7 per cent. This follows a downward revision of the Italy growth forecast by the Bank of Italy (in the middle of January) to 1%, and a revision (earlier this month) by Confindustria, Italy's largest employers' lobby, who slashed their forecast also to 0.7%. Back at the start of January I said this on my Italy blog:

I personally will be very surprised if we still see calendar year 2008 anything like as high as 1.8%, but more to the point even 1.3% may be rather on the high side if we get a significant deterioration in the external environment, especially in Eastern Europe on which Italy is fairly dependent, and where the Italian banking sector has significant exposure. So that puts me much nearer to Pillona's "basement bargain" number of 0.5% than to any of the others. One of the reasons for my pessimism relates to my assessment of Italy's current trend growth rate, and to the level of fiscal and monetary tightening which may be operating on the economy even as it slows. During 2007 the Italian govenment has been running a fiscal deficit of comfortably below the 3% of GDP required by the EU commission. But since this fortunate situation was in part acheieved by the use of one off measures, and in part by the strong tax inflow from the above trend growth, the government will need to maintain a comparatively tight fiscal stance to keep things on course, and any attempt to further loosen may run into real problems with the EU commission and the credit rating agencies. And as I keep arguing, it is very hard to see an accomodative monetary posture from the ECB in the near future. The IMF in their October World Economic Outlook came in with a similar figure of 1.3% for 2008, the Economist Intelligence Unit is forecasting 1.7% in 2007 and 1.4 in 2008, and the latter 2008 figure was also endorsed by the EU commission in its November forecast.


As I indicate, my own view is well to the downside of all this. The only apparent bright spot on the horizon is employment, but I am dubious that in the context of Italy's ageing workforce this will work through as some are hoping, as I expain at some considerable length in this post here. My opinion is that Italy will enter recession at some point during 2008, and that we may well have 2 consecutive quarters of negative growth. The continuing high euro will maintain pressure on Italian exports, and high oil and food prices will maintain pressure on the inflation front, at least in the firts half of 2008. At the same time, and despite rumours that Romano Prodi's government is compemplating a large tax cutting package, I anticipate that the fiscal environment will remain tight. Italy's large (106% GDP) accumulated debt, and the vigilance from the gentlmen at Standard and Poor's and the other credit rating agencies more or less guarantee that.

I wouldn't say it exactly makes me happy to be being proved right here, but we do need some more realistic perspective on Italy's current growth potential from those responsible for forecasts and policy, and some more realistic appraisal (ie of population ageing) to try and understand why things are this way, rather than assuming it is all to do with some sort of congenital weakness on the part of the Italians.

The Commission lowered its country forecasts for Germany (to 1.6 per cent, from 2.1 per cent), and France (to 1.7 per cent, from 2.0 per cent), for the UK (to 1.7 per cent, from 2.2 per cent), and for Spain (to 2.7 per cent, from 3.0 per cent). Of these the French one looks to be the most realistic. The German forecast obviously contains strong downside risk, while the Spanish one seems to be talking about "another country" from the one I live in, when we come to look at the rate of the slowdown in the real economy (retail sales, industrial output, services etc), and add to this the growing tensions in the banking and financial sectors. I would stick my neck out and go for sub 1% growth in Spain this year, and feel reasonably comfortable with this.

Economy and Finance Commissioner Joaquim Almunia stressed the Commission’s view, which has been expressed many times since the financial market turbulence began last August, that the European economy would weather the storm because of its "sound fundamentals" – stable public finances, no huge current account deficits, relatively low unemployment and stronger international competitiveness. The strange thing is that he actually comes from Spain, a country which, it is true, has sound public finances at this point, but does have a huge (or whopping) current account deficit, which since last autumn it is having trouble financing since the monthly inflow of funds has dropped by around half, high (and growing) unemployment (around 10%) and poor producyivity growth (one of the worst in the EU) and hence comparatively weak international competitiveness. For these and many other reasons I suggest the 2.7% number is absolutely "pie in the sky", and may have a lot more to do with the fact that Spain is going to have elections in the middle of next month, with Mr Almunia's own party (PSOE) attempting to secure re-election.

On the inflation side the Commission raised its estimate for 2008 for the 27-nation EU to 2.9 per cent from the earlier 2.4 per cent, a revision which won't make the task of the ECB any easier when it comes to trying to use monetary policy to address the growth slowdown issues.

The Spanish Banks' Growing War Chest

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.


Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.



During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?


Update

Geert asked me a question in comments, possibly reflecting some of the difficulties people may be having with this post.


"I must confess that I don't really fully understand this post."


Since I have tried to answer at length, I though it might be useful if I reproduced my explanation above the fold.

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think,though, that to get the background here you need to go through the posts on my Spanish blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

Toshihiko Fukui's Term At The BoJ

Toshihiko Fukui will retire as governor, after five years at the helm of the Bank of Japan, on the 19th March. His successor may well be announced this week. This morning in the Financial Times David Pilling has a long, and very "fair and balanced" asseessment of Fukui's time at the BoJ, which is more than worthwhile reading for those of you who would like to understand the workings of this venerable institution just a little better. As Pilling's concluding paragraphs make clear, what would seem to matter most in this case isn't so much what just happened, as what gets to happen next:

“Fukui has often been portrayed as chomping at the bit to raise rates,” says Ben Eldred of Daiwa Securities “The truth is that Fukui’s BoJ has been fairly pragmatic – waiting until relatively late in the economic cycle before raising rates, doing so only very gradually and pausing as soon as it became clear that the global economic outlook had worsened in 2007.”

The pause to which Mr Eldred refers has lasted a year. As well as a response to international circumstances, the delay also reflects the failure of the domestic economy to click into gear as Mr Fukui has long predicted. The governor has continually stressed his belief that record corporate profits will feed through into higher wages and consumer demand – a “virtuous circle” that might have been a good justification for the bank’s forward-looking policy.

Unfortunately, it has not panned out. Wages have stalled or even fallen as global competition, coupled with labour market and demographic changes, has short-circuited the normal mechanism by which profits flow into remuneration.

This has left Japan’s economy running on only one, export-led engine and flying too close to the deflationary ground for comfort. What headline inflation there has been is due almost entirely to higher oil and commodity prices. If commodity-led inflation fades – as many predict if the global economy slows – Japan could yet crash-land back into deflation.

Markets are factoring in the possibility that the BoJ’s next rate move will be down – not up as the governor has long intimated. It would be a severe blow indeed for the bank to put hard-won interest rate rises into reverse. But if the day for such a decision arrives, at least it will not be Mr Fukui’s to make.

Basically I think Fukui's big bet was that domestic consumption would prove strong enough to provide a second leg (in tandem with exports) for the Japanese economy. As Claus Vistesen details at great length here (and here) - and as Pilling also seems to accept -this view seems to be inadequate, and fails to get to grips with the malaise which is affecting the Japanese economy. And as if to give just one last kick to this now thoroughly wobbly perspective, todays index for December services has just been published by the Japanese Trade Ministry. The tertiary index, which is a measure of the money households and businesses spend on things like phone calls, power and transportation, declined 0.6 percent from November. The Ministry listed the following sectors as having declined:

1. Finance and Insurance, 2. Services, 3. Compound Services, 4. Wholesale and Retail Trade. Industries that contributed to the increase are as follows:1. Eating and Drinking Places, Accommodations, 2. Real Estate, 3. Learning Support, 4. Electricity, Gas, Heat Supply and Water, 5. Medical, Health Care and Welfare.

Although the index actually rose some 0.2 percent over the fourth quarter, this latest sign of weakening will certainly not come as good news for Fukui as he prepares to clear up his desk.