Croatia: On The Brink of What?

As Croatia enters the final stage of its EU membership talks, it is perhaps a fitting moment to review the other half of the picture, namely where the Croatian economy finds itself, and what the outlook might be for a continuing convergence with the requirements of Euro membership. Understandably, EU officials are fairly cautious about the likely shape and progress of the forthcoming talks (the Union has, after all got rather a lot on its plate at the moment), but Croatian Prime Minister Jadranka Kosor is decidedly more optimistic, since while she recognises that this last phase is likely to be "really difficult and demanding" she still believes that negotiations could be concluded by the end of the year, which would mean that membership in 2012 would become a possibility.

Whatever view you take on the likely progress of the talks, one topic on which it is hard to be optimistic in the short term is outlook for the Croation economy. Despite the fact that the country may not have too many difficulties complying with the original Maastricht Euro membership conditions, the newfound interest among those responsible for EuroGroup decisions for sustainability and longer term competitiveness mean that a country whose economy has as many structural distortions in it as Croatia’s does may well find a growing number of new obstacles thrown across its path.

Reeling Under The Shock

Unsurprisingly, the global economic and financial crisis have taken a significant toll on the Croatian economy. Given the background of a large current account deficit, a high level of external debt, and significant balance sheet exposures to interest and exchange rate risks, the pressure from reduced capital inflows was always going to cause problems, and it did: financial asset prices collapsed, sovereign spreads shot up, and the Zagreb stock market plunged.



As a result of the combined impact of the difficult external conditions which prevailed and the ending of the domestic credit boom Croatia’s GDP fell by some 5.8% in 2009, following a number of years of strong (if not sustainable) growth. Even though in the first three months of this year there were been some tentative signs of recovery the economy was still down by 2.5% on an annual basis.



Personal consumption fell by 4.1%, which was not surprising given that new credit has all but dried up, but more worryingly the drop in fixed capital investment accelerated to an annual 13.9% during the three month period. Government consumption fell for the third consecutive quarter and was down by 1.1%, and the only positive point was the net trade impact, since the export of goods and services rose by 3.6% (following five consecutive quarters of decline) goods and services imports fell by 4.8%.








Exports The Only Realistic Way To Pay Down The Debt

Given the high level of external indebtedness of the Croatian economy (net external debt is currently running at around 95% of GDP) and the sensitivity of the financial markets to fiscal deficits, there is likely to be little in the way of a revival in domestic demand, depending as it does on the availability of credit.

Which leaves exports to pull the cart. But this is where the high level of euroisation of the economy becomes a problem since obtaining export growth after many years where the country has run a substantial trade deficit is hardly going to be easy.






In fact financial euroization even increased during the crisis, and at the end of 2009 about 70 percent of the total bank credit and over 65 percent of bank deposits were either denominated in or indexed to foreign currency. As the IMF note in their latest report price and cost indicators suggest that competitiveness has been deteriorating in recent years and Croatia’s real effective exchange rate is surely overvalued. Yet all those Euro denominated loans make it very difficult for the authorities to contemplate outright devaluation of the kuna, while the prospect of having to manage an internal wage and price correction is hardly an attractive one, as we can see in the Latvian and other cases.

Croatia’s unit labor costs have risen significantly faster than those of its principal trading partners in recent years, due largely to the fact that wages in the private sector were pushed up by rapid wage growth in the public sector. As a result, the overall wage level is high relative to Croatia’s productivity following non-competitive wage setting in a public sector which employs around a quarter of the labor force, not counting public enterprises.

As the IMF note, rigidities in the Croatian economy are substantial, with strong labor regulations constraining labor market flexibility, resulting in high employment in the gray economy, a proliferation of temporary work contracts, both of which reduced employers’ incentives to expand employment during the boom years. The impact of the grey economy is clearly reflected in the disparity between the official unemployment rate (of around 19%) and the EU harmonised one accepted by Eurostat (which shows unemployment to be nearer 10%).




And Then There's Population Ageing To Worry About

Another factor to be taken into account is the rapid ageing of the Croatian population, following many years of very low fertility, and a steady increase of life expectancy. Croatia’s working age (16-65) population peaked in the early 1990s, and is now in long term decline, while the old age dependency ratio is set to rise and rise. Indeed about a quarter of Croatian population are now retired, a fact which also reflects the presence of relatively generous pension and social benefits conditions, benefits which were available during the years of increasing borrowing, but which are surely now hardly sustainable as the time comes to pay back some of the accumulated debt.







Looking ahead to the remainder of 2010 the contraction will most likely continue. The IMF forecast in April a miniscule 0.1% growth, but since that time optimism for the global expansion has waned, and in particular demand from many of Croatia’s trading partners is likely to be more muted than anticipated. Investment is unlikely to recover its earlier momentum, burdened as it is by an indebted private sector and a public sector looking to make cut-backs. Private consumption will also remain under the influence of the contraction in consumer credit. While exports should remain supportive, with imports continuing to remain low given the weak domestic demand, goods trade exports may not be as strong as some expect given the weaknesses in the European recovery, while tourism may well be affected by the high levels of unemployment which still exist in many of the relevant countries. Rising fiscal concerns will only add to the slowdown of the EU recovery (given the negative demand impact of the harsher fiscal policies) so a contraction of between 1% and 1.5% in 2010 does not seem unlikely.

In addition Croatia remains vulnerable to contagion risks from adverse market sentiment in the region. This contagion could take the form of tightening financial constraint such as a rise in borrowing costs, or a reduction in cross-border flows. On the other hand the absence of Greek banks in Croatia and the limited real sector linkages with Greece should minimize the risks of direct spillovers from that quarter. The real threat would come from a more generalised crisis across the EU’s Southern and Eastern periphery.


On The Brink Of What?

So, after living for many years on borrowed money and borrowed time, running a significant current account deficit and accumulating a large external debt, Croatians are now likely to be faced with the harsh reality of living in a rapidly ageing society at a time when external competiveness has been severely undermined.



In the short term the economy may have stabilised, but in the longer term the challenges are immense, and should not be underestimated. Like many economies across Eastern Europe, Croatia is going to have to straighten out the structural distortions and pay down its external debt at just the time the oncosts of societal ageing are going to start to bite deep.





In addition a rigid labour market and an overweight public sector pose serious problems for the transition to a dynamic and competitive economy. Many changes are needed, and most Croations are only all too well aware of this fact. But one factor which doesn’t seem to get the attention it deserves is the continuing threat to long term economic stability posed by having such a low (tfr 1.4 – or only two thirds of replacement) birth rate.






To make matters even worse, the wage differential with Croatia's West European neighbours means it is an attractive proposition for many young people to go abroad to work, and while the remittances all those migrant workers send back may be very welcome back home - especially given the difficulties Croatian industry has in selling abroad - a country with fertility well below the replacement rate should not be exporting labour to pay down a current account deficit. The way to settle the debts is to provide work in export industries so people will stay at home, and contribute to the maintenance of the health and pension systems.



Like most societies in Eastern and Southern Europe the Croatia needs to address this other imbalance, and it needs to start to do so soon, since the clock is ticking, and it won’t stop doing so. At this key moment in the country’s history it is hardly difficult to recognise that Croatia is effectively on the brink of something, but whether that something is going to be long term sustainability rather than something that it is better not to think about, well, the answer to that question can only be given by the Croatians themselves.

Is Estonia's Euro Membership A Done Deal?

Well, if you read this report from Euractiv, citing unnamed EU Commission officials, it is:

"If nothing extraordinary happens, the Commission will give its positive opinion for the accession of Estonia to the euro zone on 12 May," an EU official said, clearing the way for Baltic country to join the euro in 2011.

There just one little snag here: that extraordinary, "fat tail" event seems to have just happened. For the Commission to be able to move forward on Estonia's Euro Membership, the ECB have to agree. And it is here that Estonian journalist Mikk Salu steps in (in Estonian in the newspaper Eesti Päevaleht, summarised in English here) and says "not so fast". Salu reports on a closed-door meeting of the Economic and Monetary Affairs Committee of the European Parliament held last Tuesday (April 13). The meeting had a single-item agenda: Estonia's membership of the Eurozone, and the meeting was attended by ECB Executive Board member Jüergen Stark. According to MEPs who attended the meeting (but did not wish to be identified), Stark was "stark": Estonia is not going to be admitted. The reason given was that in the wake of the recent crisis affecting the Eurozone, new criteria will be introduced - including per capita GDP and competitiveness sustainability - and on these counts Estonia will not qualify.

Salu also spoke to Estonian MEP Ivari Padar, who attended the meeting and confirmed the substance of the discussion, although Padar did try to mediate the situation slightly, saying, "you know, he is a central banker, and central bankers are a conservative lot", etc etc. On phoning the ECB itself and the Commission the only reply he got to a straight question seems to have been "no comment".

Basically, as I said, maybe the ECB are a conservative crowd, but I think it is very hard to see Estonia being admitted to the Euro without ECB backing, and indeed looking at what is happening over in Greece at the moment, and in the German Constitutional Court, I think it is very hard to see any new members at all in the immediate future. Consensus thinking right now seems to be more towards small(er) is more beautiful.

None of this surprises me, indeed when I wrote my last post on Estonia, back in February, it seemed to be an increasingly likely outcome.

But as Fitch pointed out when they raised their Estonia outlook, while eurozone membership looks increasingly possible it is not yet certain. Fitch warned in their report that even if Estonia meat all the formal Maastricht reference criteria for euro entry there is still a risk that the European authorities' interpretation of these same criteria could lead them to reject Estonia's application. According to Fitch, in Estonia's case uncertainty surrounded whether the idea of "sustainable price performance" was going to be consistent with the deflation which is to be expected from such a severe recession, after inflation had so recently been in the double digit range. The agency also added that one-off measures taken by the government to reduce the budget deficit in 2009 could also count against it in the EU authorities' judgment of whether the medium-term budget plans are credible.

The first point is an important one I think, and is reiterated by the ECB's own Jürgen Stark in an interview given to the German magazine Der Spiegel for this weekend: "But when taking on board new members, we will need to take an even closer look, concerning the data and the sustainability of convergence," he is quoted as saying.

Indeed if we go back to the 172 page EU Commission document leaked to the German magazine Der Spiegel last month, the EU Stability and Growth Pact is increasingly going to focus on issues surrounding competitiveness as well as on fiscal deficit ones. That is what the whole deabate over the Greek and Spanish economies which EU leaders are engaging in this week is all about. And any country which is not considered to be in completely good health under the SGP criteria is hardly likely to get the green light from the ECB and Ecofin.

It is obvious that the Estonian economy is still suffering from earlier structural distortions which have not yet been corrected. If we come to the consumer price index, this was only down about 2% in 2009, far short of the deflationary adjustment which will be needed to restore growth and competitiveness.

And to cap it all, for the first time since the start of the financial crisis, Moody's has chosen this, of all, moments to up its ratings outlooks for Lithuania, Latvia and Estonia. The decision was apparently based on the idea that the contraction has been stabilized (which it has), but as we are unfortunately about to see, stabilization and getting back to growth are not one and the same thing. In Estonia's case the more favourable rating was a reflection of the expectation that the country "will soon be able to join the eurozone":

Estonia’s “economy and banking sector are exhibiting signs of a gradual recovery,” Kenneth Orchard, a Moody’s analyst in London, said. “Equally important, the government’s impressive fiscal performance in 2009 means that Estonia is likely to be permitted to adopt the euro next year.”

And if I'm reading this report aright, Latvia just declared a 9% general government fiscal deficit for 2009, well above the 6.7% which was originally estimated. Cry victory if you will, but perhaps it would be prudent to wait till the war is actually over before you cry it too loudly.

Lies, Damn Lies And Statistics In Sweden (of all places).

This post is basically a follow-up to my earlier Just What Is Going On In Sweden? one, and has been stimulated by an article which appeared in Bloomberg earlier in the week, detailing a number of issues which have arisen in conjunction with the Swedish Statistical Office.

The Story So Far

Basically, most of us were, I imagine, pretty shocked to learn at the start of March that Sweden had unexpectedly fallen back into recession in the fourth quarter of last year: we were shocked not only because the news in itself was bad, but also because we had been under the impression that the Swedish economy was recovering nicely. Yet despite all our prior expectations the Swedish statistical office reported that gross domestic product contracted by a seasonally adjusted 0.6 per cent in the fourth quarter of 2009 (when compared with the previous three months), while, in addition, the third-quarter figure was revised to a 0.1 per cent quarterly decline (down from an original 0.2 per cent gain). And two consecutive quarters of contraction meant that, technically speaking, Sweden was well and truly back in recession.

Faulty PMI Readings

But there was more, since if those of us who had been following the performance of the Swedish economy were more astonished than surprised, it was because the Silf Swedbank manufacturing Purchasing Managers Index had been showing not only robust growth for Sweden's industrial sector, but even suggesting it had been experiencing one of the fastest rates of expansion on the entire planet (and for several consecutive months, see chart below).



Yet far from expanding, Sweden's manufacturing industry has now been stagnant, and for many months. At least according to data supplied by the Statistics Office to Eurostat (see chart below) it has. Of course, maybe the data the Stats Office has collected about manufacturing output is faulty, but looking at the GDP numbers that seems unlikely, unless of course even the revised GDP numbers need revising...



Yet Another Shoe Drops

And just to show that concerns about the kind of data we have been seeing out of Sweden of late are not unfounded, we have the case of what Cecilia Skingsley, head of macro research Swedbank calls the "shoe adventure". Basically, and as Bloomberg reports, when the Riksbank raised interest rates in September 2008, 11 days before Lehman Brothers collapsed, Sweden's central bankers based their decision on inflation figures from the Statistics Office. Unfortunately, later that month four months of inflation data had to be corrected after the Office discovered that a computer inaccurately calculated a 28 percent increase in shoe prices (although the problem, I imagine, lay with the person who entered the data, rather than a malfunctioning computer). As Cecilia Skingsley points out, apart from the impact on central bank monetary policy, “The shoe adventure meant we ended up with a different price base amount, which in turn affected benefit payouts.” In fact Bloomberg estimate that the mistake cost the government something over 600 million kronor ($84 million) in excess benefit payouts.

Statistics Sweden boasts a proud career which dates all the way back to 1686, when a church law became the basis for the Swedish population census. It released 74 publications last year and 371 press releases, cataloging everything from how many moose are shot annually, to the number of Swedes that are named after a Christmas tree ornament. But for all its venerable history, the office (which employs 1400 people) has evidently seen better days, since over 10 percent of 71 statistical reports published in February and March were corrections of earlier data releases.

And it isn't only the inflation and GDP data which has been causing problems, Figures for local government finances were corrected last month to a deficit of 2.2 billion kronor from a surplus of 2.4 billion kronor. The Swedish government uses these figures to draw up its annual budget.

Another area of contention revolves around central bank rates and home mortgages. The Statistics Office had to correct on Feb. 25 its estimate for the proportion of Swedish households with adjustable-rate mortgages, revising the time series as far back as far as September 2005. The figure for December was adjusted to 58 percent from 48 percent. The revision prompted speculation the Riksbank may have forecast higher-than-necessary interest rates at its February 10 meeting.

All these issues are rather serious, even if some are more important than others, and certainly go to show that statistical issues in Europe extend well beyond those we have seen in the recent highly publicised Greek case. Bloomberg cite many analysts who are rightly angry about the current state of affairs, but let me add my own personal beef about Swedish statistics here: the lamentable state of the SILF Swedbank PMI readings has lead me to suspend Sweden from my monthly global manufacturing report. Quite frankly this sort of faulty measurement only fuels the (largely unjustified) scepticism which tends to surround this kind of qualitative performance measure, yet from what I can see Markit Economics country reports are, by and large, reliable within a reasonable margin of error. Which only makes the Swedish case stand out further, and makes it, at least for my part, incomprehensible that Swedbank haven't felt the need to make some sort of correction/statement on the topic.

China's Recent Trade Deficit: Is What You Yuan What You're Gonna Get?

China is self-evidently both a minefield and a potential graveyard for would-be global economists, the sort of place where reputations are made and lost in the twinkle of a dragon's eye, so I think had better tread rather carefully here. However, having duly noted that only fools rush in, here I go...

China ran its first monthly trade deficit in six years in March, a development which encouraged the country's Commerce Ministry to up the volume a bit on the argument that the need to revalue China's currency was being greatly exaggerated. The debate surrounding renminbi revaluation has also given us one more reason - beyond the recent accusations of the US SEC - to cast a watchful eye over how things are done at Goldman Sachs: the outrageous suggestion from their Chief Economist Jim O’Neill (in this Financial Times article) that if things carry on as they are, China will soon overtake France as the principal destination for German exports (see in depth analysis below).

The problem is, that with the argument having become so politicised, and with so many different interested parties at work, it is fast becoming hard to see wood from the trees, or even the sandals and tee shirts from the high speed trains.

A One-off Deficit?

Looking through the data, it would appear that while China's March performance was undoubtedly a one-off, import growth has been outpacing export growth for some months now. And with imports of commodities surging, and with them commodity prices, it was not really that surprising to find that China swung into a trade deficit of $7.24 billion in March, from a surplus of $7.61 billion in February, according to figures issued by China's Customs agency. Overall imports were up 66% from a year earlier in the moth, with purchases of crude oil and copper at near-record levels in volume terms.



In fact Chinese officials had been signalling for some weeks that March could produce a rather exceptional trade deficit, a development they highlighted to show how China's strong growth has been boosting its purchases from other countries. But beyond the March reading, China's trade surpluses have been shrinking as the government stimulus plan, and extensive bank lending, have boosted domestic demand, and indeed the cumulative trade surplus for the first quarter of 2010 fell 77% from a year earlier to hit $14.49 billion.

On the other hand, according to the Chinese customs department, the March deficit mainly comes from trade with Taiwan, Japan and South Korea, while large surpluses continued with the U.S. and the European Union.



Evidently one month's data is unlikely to convince anybody, and especially when there is so much doubt surrounding the sustainability of China's domestic consumption growth, so the March data is surely unlikely to silence the deafening roar of international criticism of China's trade policies, and indeed European voices are now increasingly being added to US ones.



Evidently March's exports may well have lower than normal as factories took their time reopening after the February Lunar New Year holiday. Exports were up in March, but the rate of increase fell to 24.3% from a year earlier, as compared to the 31.4% annual growth registered in the first two months of the year, although it is hard to tell how much of this weakening was a Lunar New Year effect, and how much the development reflected domestic demand weaknesses among China's main customers.

Looking at the trade balance chart (above), it is clear there is normally a dip in February/March, and this year we may have simply seen an exaggerated version of what is really an annual phenomenon. Certainly, till we see a bit more data it will be hard to separate a stimulus-based surge from the trend.

China: The New Import Powerhouse?

Separating surge from trend however does seem to have turned into something of a problem for Goldman Sachs Chief Economist Jim O’Neill, since he argued recently (in a widely quoted piece) that:

"As far as China’s involvement with the rest of the world goes, the real story since the worst of the crisis is not China’s recovering exports but China’s strong imports. The forthcoming trade release – interestingly due a few days before the Treasury report – is likely to demonstrate enormous import growth again, absolutely and relative to exports. This is seen not just in Chinese data, but in those from many other important trading nations. Indeed, quite remarkably, Germany’s trade with China is showing such strong growth that by spring next year, on current trends, it might exceed that with France".

This is quote a claim, and evidently impressed both Tyler Cowan at Marginal Revolution, and the Economist Free Exchange Blog, since they quote precisely this extract in support of their argument that the threat to global economic stability represented by China's trade surplus is being rather overdone (which may or may not be the case), and they obviously take his China overtaking France claim as good.

As a student of German export performance, I however did not. The most important point to bear in mind is that Germany basically missed out on the first wave of China import growth (with the market being largely dominated by Japan). To give an indication, in 2008 German exports to the Czech Republic and to China were of about the same order of magnitude, a data point which is reasonably suggestive of the extent to which German export growth 2005 - 2008 was dependent on growth in Central and Eastern Europe (both inside and outside the EU). Growth in this market has, of course, now come screeching to a halt, hence the renewed German interest in China, and in general terms, non-European export destinations - which is one reason why, at the end of the day, the sharp drop in the value of the Euro has been as much to Germany's advantage as it has to that of any other Eurogroup country.

So the key point to note is that German exports to China started from a comparatively low base, and hence even a sudden sharp surge does not make that much of a dent in the rankings list.

So just what are the facts? Well, according to the most recent release from the German Federal Statistical Office, German exports to China were worth 36.5 billion euros in 2009. Which means that, compared to 2008, exports to China were up around 7%, while total German exports declined 18.4% during the same period. So evidently the importance of German exports to China has been growing, but nothing like as much as O'Neil claims. Really!

Given that German exports to China have been running at something like 40% of exports to France, I thought I would take a look at the actual data. There are two available sources for such information: the German Statistics Office, and the OECD. Here is will use the OECD data. As can be seen in the first chart, there can be no doubt that German exports to China have been growing steadily and impressively over the last 3 years, but it is equally evident that they are still well, well short of those to France, and by no stretch of the imagination could it be thought feasible that China will overtake France as an export destination in the near future.




The second chart puts things in a longer term perspective, and what stands out is the fact that while German exports to China have followed a steady path, while those to France slumped significantly in 2008 as a result of the global economic crisis. So what this means is that exports to France are unusually low (and thus it is impossible to talk of trend), while those to China are unusually (and possibly unsustainably) high, given the impact of the stimulus programme. So to extract his "trend" (which is in no case valid) Goldman Sachs' Chief Economist seems to be assuming a worst case scenario for France and a best case one for China: hardly a balanced methodology. Or does Jim O'Neil really want to tell us he is discounting the possibility of a sustained recovery in demand in the OECD economies? Even without the benefits of our own "proprietary indicators", simple testimony of the naked eye should tell us he is wrong here.



Which is a pity, since stripped of its exaggerated claims, his substantive argument may not have been entirely false. Also we should not forget that Germany imports Chinese products (55.4 billion euros worth in 2009, as compared to the 36.5 billion euros worth of exports), and ran a trade deficit of 18.9 billion euros last year (or roughly 50% of the total value of exports) while Germany ran a trade surplus of some 27 billion euros with France.

Whatever You Yuan

In fact the impact of a revaluation in the renminbi may be much more complex than many seem to be assuming, and one good example of the kind of perverse consequences we may see is offered us in a really interesting research note from Alexandre Schwartsman (Bank Santander, Brazil) entitled "What Do You Yuan?"

There is an ongoing debate about how China should handle its currency in face of both political pressures and signs that inflation may be accelerating. Such challenges raise the possibility of the resumption of yuan appreciation trend that prevailed between 2005 and 2008. Of course, we claim no special knowledge on whether or when Chinese authorities will decide on the issue, but in our opinion, eventual decisions on that could have considerable implications for Brazil.

We do not think, however, that the direct effects through the trade channel are the most important part of the story. While it is true that China has become the largest market for Brazilian exports, we rush to note that it still represents only 13% of Brazilian exports (which, in turn, are equivalent to about 12% of Brazilian GDP). Moreover, even its current status as the main customer for Brazilian exports is threatened at the margin by the recovery of exports to the U.S. and Argentina.

Indeed, we believe the main channel of transmission to Brazil is likely to be through commodity prices. We argue, with the help of a small theoretical model, that a stronger yuan should imply higher commodity prices in dollar terms. In fact, it is possible to show that, if dollar commodity prices do not change in response to a stronger yuan, there would be excess demand for commodities, which would eventually drive their dollar prices up.

The economic intuition which lies behind Schwartsman's argument is really very simple, but the logic is also quite compelling. Basically, it depends on two points:

i) China domestic demand growth is more energy intensive than the OECD average
ii) China is large enough to be (to some extent) a price setter, and not simply a price taker.

Put another way, the income elasticity of energy consumption in China is greater than it is in the developed part of the Rest Of the World. This also applies to the energy component of agricultural produce, with important positive consequences for countries like Brazil. That is to say, China consumes energy directly, and indirectly, via the energy input which goes into the food production (fertilizers for soya beans in Brazil, for example) that it outsources. So there is a direct, and an indirect impact.

The net consequence of this, is that the Santander analyst expects the dollar price of commodities like oil to rise sharply on the back of any significant yuan revaluation, making China richer (in relative terms), and logically the developed world poorer. Again, and put in other words, the terms of trade are about to change against Europe, the US and Japan, and possibly bigtime, as the Yuan and other emerging market currencies rise. On the other hand, Brazil and other resource rich emerging economies stand to benefit, equally bigtime, in what will be one of the largest rebalancings of the global economy seen in many a long year. The main losers, it seems to me, will be the long-term structurally unemployed we now have in the developed world, and those living in poor countries with few natural resources.

Where Do We Go From Here?

Where we go from here on the China trade front is now very hard to tell. Evidently, on the one hand, evidence continues to mount that more flexibility in yuan parities in in the pipeline. But will the much sought after revaluation really do all that heavy lifting that is being expected of it? After all, Germany's currency was effectively revalued upwards on joining the Euro, and the country then spent several years putting downward pressure on cost elements, with the result that the German trade surplus was even larger (as a % of GDP) in 2008 than it was in 1998. And China's almost unique demographic trajectory also suggests that promoting internal consumption as a growth driver may be up against significant constraints. Life Cycle Theory Nobel Franco Modigliani, in what was his final published paper (2005) - The Chinese Saving Puzzle and the Life-Cycle Hypothesis - drew attention to this oft neglected dimension which evidently forms part of the problem. At the very least, some simple economic theory suggests that all may not be as simple here as it seems at first sight.

On the other hand Chinese officials, far from showing signs of alarm at March's deficit, generally seem to have welcomed the development. According to Zheng Yuesheng, director of Statistics at China's customs office, "This kind of deficit is healthy as it happened while both imports and exports experienced rapid growth," and in any event, as he also points out, China will undoubtedly continue to run (smaller) trade surpluses over the long term. This, at least, has the benefit of being a realistic, and pragmatic assessment of the situation. All we need now is for a bit of this realism and pragmatism to work its way steadily westwards.

The Debt Snowball Problem

OK, just for a change let's start with some math. The increase in a country’s sovereign debt stock to GDP ratio is given by the following formula:



where D is the total debt level, Y is nominal GDP, PD is the primary deficit, i is the average (nominal) interest paid on government debt, y is the nominal GDP growth rate and SF is the stock-flow adjustment.

Now, if like me, you don't especially love maths, you may want to ask "what the hell does this rigmarole mean?".

Well, in simple plain English the above equation - which in fact comes from the recent Danske Bank report on EU Sovereign Debt- means that movements in the critical debt to GDP level depend both on the level of the annual fiscal deficit (the primary deficit, on which so much attention is currently focused in the Greek case) and on changes in the ratio between the value of the stock of debt and the value GDP. The key term is the one in brackets, and it is often referred to as the “snow-ball” effect on debt - the self-reinforcing effect of debt accumulation (or de-cumulation) arising from the difference between the interest rate paid on public debt and the nominal growth rate of the national economy.

Nominal here means GDP values before adjustment for inflation (what is known as current price GDP). So what we can say is that the trajectory of (for example) Greek debt to GDP going forward (and thus the effectiveness of the adjustment programme) depends critically on only three main variables - the rate of deflation/inflation, the rate of GDP growth, and the interest spread charged on Greek bonds. Ideally, Greece needs solid GDP growth, inflation, and a low spread on Greek bonds vis-a-vis German ones. The problem is the Greek Stability Programme may achieve none of these.

In the first place, the attempt to reduce the primary deficit will involve withdrawing some 10% of GDP in government demand from the economy in the space of three years (to go from an annual fiscal deficit of 12.7% a year in 2009 to one of 2.8% in 2012). The Greek government plan projects the economy to shrink by 0.3 per cent this year before rebounding with growth of 1.5 per cent in 2011 and 1.9 per cent in 2012. Most analysts are very sceptical about this forecast, since sustaining any kind of GDP growth under the present circumstances will be hard, and I think the most realistic expectation is that the Greek economy will see some sort of annual contraction during each of the three relevant programme years.

Secondly, to keep the debt GDP level from snowballing Greece needs inflation. But to get GDP growth Greeec needs to restore competitiveness, and this means (given they have no currency of their own) price and wage reductions (ie the so called internal devaluation) so they will have deflation not inflation, or they will not "correct" and move towards GDP growth.

Thirdly, and this one is easier: Greece needs to reduce the bond spread to keep interest rates on the debt as low as possible. This is doable, should Greece be able to convince market participants a viable correction plan is being operated. The ECB could also play a role here. But Monsieur Trichet, in his wisdom, said two things which were relevant in the post-monthly-meeting press conference yesterday. In the first place he said, quite correctly "we are here to help" - which I read as meaning that he is saying to the Greek government that "you take the steps you need to take, and we will help with liquidity", but on the other hand he also said "we will make no exception for individual countries" in setting our collateral rule, which effectively means that (from 1 January 2011) should Greece lose it's A2 status from Moodys (by two notches), the ECB will not be able to accept Greek bonds.

The first statement clearly offers support to the Greek spread, but the second (which might lead people to think they should start to steadily remove Greek sovereign debt from their portfolio) obviously wasn't.

It was hardly surprising then that the yield on the 10-year Greek government bond remained above 6.1% this (Friday) morning, up around 0.2 percentage point from early Thursday. The yield stood some 2.79 percentage points above the yield on the comparable 10-year German bund, the euro-zone benchmark, up about 0.25 percentage point from early Thursday. The spread even widened as far as 2.9 percentage points at one point yesterday, following the ECB meeting, and details of the Greek government's budget plan.



So basically, to make Greek debt to GDP dynamics sustainable, and avoid the snowball effect, my guess is you need two things:

a) to convince investors that Moody's will not downgrade, or some that some other form of support will be offered to the country.

b) some solution to the restoration of competitiveness dilemma. Basically, at the moment the Greek government has no interest in carrying out an internal devaluation, since the deflation impact on the debt formula would simply precipitate the snowball. But if they don't carry it out the economy will not return to growth, and investors will lose confidence and the bond spreads widen again, effectively setting off the snowball via another route.

So there needs to be a quid-pro-quo here, where the EU authorities undertake to restructure Greek debt in some way via the use of (eg) EU bonds (the famous bail-out) should Greece comply with a certain number of specified conditions first. Now many will scream at this point, "well they got themselves into this mess, now let them get themselves out of it". But matters are never that simple. Greek sovereign debt is in part a by-product of the eurosystem experiment, which made the accumulation of such debts at apparently cheap rates of interest possible (although none of those responsible for overseeing the system seem willing to recognise this). The Greek people have to accept their share of responsibility for the mess, and for the behaviour of their elected representatives. But there should be a limit to the "financial penalty" imposed. As Martin Wolf says in the Iceland context:

The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons. Asking a people to transfer as much as 50 per cent of GDP, plus interest, via a sustained current account surplus is extraordinarily onerous.

In fact, asked in a Reuters poll carried out between January 11-14 what they felt was the the probability of Greece actually seeking a bailout this year, the median response from around 30 analysts that they would was 20 percent, with the same likelihood being expressed that it would be necessary at some point in the next five years.

This is not a very high probability at this point, but then when the same sample of analysts was asked about future ratings decisions, some 16 of the 27 analysts involved said they thought Moody's Ratings Service would downgrade its rating from A2 to a below-A rating by the end of the year. This is a much more significant result.

As it happens, I personally don't agree with either verdict, since in the first place Moody's are concerned with long term sustainability, so I doubt they will change their view on that one this year if the Greek government follow an agreed EU programme, while I do think (for the reasons expressed above) that some sort of Greek "bail-out" will be necessary over the next five years (to stop the snowball) if the government does what it has to do.

But all of this only serves to highlight juest how precarious the Greek situation actually is, in particular since the government still haven't accepted the need for internal devaluation, which is the only policy which will really restore growth. With a majority of analysts thinking Moody's will move to a below-A rating by the end of the year, and Monsieur Trichet saying that as of 1 January 2011 the ECB will not accept such bonds as collateral for lending, something, somewhere is likely to give, which is why I think the Greek government should at this very moment be throwing itself into the welcoming arms of the IMF before matters reach the point of no return on the spreads and the debt snowball. To do otherwise would be to risk far greater problems in a future which will not be that far away.

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

“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.

Double-Dip Worries In Japan and Germany

Whoever said economists are people who don't ever get anything right?

"Economic growth in Germany probably stagnated in the fourth quarter from the previous three months, the Federal Statistics office said. Still, the figure is “surrounded by uncertainty,” Norbert Raeth, an economist at the office, said in a press conference in Wiesbaden today."

So German GDP was probably more or less flat quarter on quarter between October and December. The figure is surrounded by uncertainty, as I pointed out in this post (Is There A Double Dip Risk In Germany? ), quite simply because German growth numbers at the moment are all about net trade and inventories, with domestic consumption in an entirely secondary role. In fact quarterly movements in private consumption have been slight for some long time now, and it fell 0.9% in the third quarter (making a 0.5 negative impact on growth - see below, the large movement which can be seen between Q4 2006 and Q1 2007 is a distortion produced by the reaction to the 3% VAT increase which came into effect on 1 January 2007).




Imports rebounded in the third quarter, meaning the net trade impact was rather negative, but inventories were built up again (after various quarters of destocking) making a large 1.5 percentage points contribution to a final 0.7 percentage points quarterly growth. Things probably inverted in the fourth quarter, with export levels dropping back in both October and November, while inventories if not actually being run down, most likely were more or less neutral (this is what the IFO survey for the quarter shows) and thus won't count as a massive plus for growth. Eventually the whole inventory story is about second derivatives: when destocking slows down, the second derivative effect, mutatis mutandis, pushes GDP up, and and when restocking slows, this pushes GDP down.

So with nothing substantial to push it up, GDP stagnates. As I started to point out back in mid November:

The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories……Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports....

That was before we got the detailed breakdown of Q3 growth. On November 28, following the publication of this data, I went on to argue that:

While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.

Which lead me to conclude that:

In Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don’t sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

Japan's Recovery Also Fails To Convince

Well, my instincts seem to have been more or less good ones, and just to show that my forecast was not simply a fluke (ie that it is backed by some sort of coherent analysis, one that is testable), I would also draw attention to my "twin" post on Japan - Double Dip Alert In Japan, dated 7 December - where I said:

"Despite recent optimism about the apparent renaisance of growth in the Japanese economy, and the heightened sense of enthusiasm which surrounds the surge in economic activity right across the Asian continent there are considerable grounds for caution about the sustainability of the Japanese recovery itself".

Just two days laters Japan's third quarter results were revised down, sharply (and for most analysts unexpectedly sharply).

JAPAN'S economy grew much less in the third quarter than initially reported, revised government data showed today, as a strong yen and deflation weighed on economic activity by prompting firms to hold off on new investments. The new data revealed that July-September's real gross domestic product grew 0.3 per cent compared with the previous quarter, much slower than the 1.2 per cent expansion reported last month, and worse than analysts' consensus forecast of a 0.6 per cent rise.

Japan may have contracted in the fourth quarter, at this point I'm not sure, given the sharp downward revision in Q3. Certainly Japan’s reliance on exports is simply further underlined by the sharp fall in machinery orders from service companies in November. In fact orders from non-manufacturing companies dropped 10.6 percent (from October) to 380.7 billion yen ($4.15 billion), their lowest level since May 1987. In addition core orders from all industries, an indicator of business investment in three to six months, also fell to a record low.

And the Japan composite Purchasing Managers Index (PMI) shows contraction over the whole October to December period. And the drop was lead by Japanese services. The headline seasonally adjusted PMI posted 42.7 in December, up slightly from 42.3 in the previous month, but still pointing to a marked reduction in business activity amongst Japanese service providers. For Q4 as a whole, the headline index averaged a lower reading than in Q3. So, despite manufacturing data pointing to a faster expansion of output, the Composite Output Index (which mirrors GDP) was stuck at a level succesting a solid reduction in private sector activity. The index, which posted 46.5, has remained below the neutral 50.0 threshold for four successive months.

Where Is The Demand?

So what's the point of all this? Well certainly not to say simply "aren't I clever now". The issues is that (for demographic reasons) the German and Japanese economies are totally export dependent (retail sales in Germany have now peaked, and are in long term historic decline, see chart below), and thus it is unrealistic to expect the global recovery to be lead by an expansion in these economies. The recovery will have to come elsewhere (in France, for a start, but with France alone there is not enough) and the export dependent economies can then "couple" to that dynamic. It is difficult to say whether or not the Japanese economy will show some marginal growth in the fourth quarter, since the Q3 revisions make for a much lower base, industrial output has risen considerably on the quarter, but the important services sector has been contracting.



Essentially, until those heavily indebted economies (the US, the UK, Spain, Ireland, Eastern Europe, etc) who formerly ran current account deficits can find a way back to sustainable growth without the aid of large government stimulus programmes, any general recovery will remain extremely weak. And the German result has, of course, implications for four quarter Eurozone growth. As I said in this earlier summary of the Q3 eurozone performance:

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.

As Gabriel Stein of Lombard Street Research puts it:

The lack of December data obviously adds an element of uncertainty to current estimates, but it does seem fairly clear that German private consumption continued to fall in Q4 2010. Given a deteriorating global environment – monetary tightening now under way in China, an end to the effects of fiscal stimuli and slower inventory drawdown/modest inventory build-up in the US and the UK – the outlook for German exports is unlikely to be that good, particularly with the euro still strong. This is bad news for Germany and for the entire euro area. A weaker euro could ease some of the pain, but that is all it can do.

So, in closing, lets just remember that German GDP fell by 5% in 2009, we are now back round the same level we were at in mid 2006 (see chart below), and we are not exactly springing back up to the old levels. That is the measure of the task we have in front of us.