European economy in a whole lot of trouble

June 11, 2009 — Mitul Kotecha

Concerns about the health of European banks, particularly German banks, and the pace of Eurozone economic recovery have intensified.  Warnings by the European Central Bank’s (ECB) about further financial sector weakness if there is not a “V” shaped recovery reveal the extent of such concerns.  Attention is increasingly focusing on a lack of transparency and the fact that European regulators are not releasing the results of industry wide stress tests in contrast to the recently released results of US bank stress tests.  Such problems have not gone unnoticed in Germany and even the bank regulator in the country said recently that toxic assets at German bank could blow up “like a grenade”. 

It’s worth noting that the IMF’s estimates for future writedowns and capital requirements in its financial stability report suggest that European banks have much more to do than their US counterparts. See an earlier post titled “Stress testing European and UK banks”.   The IMF repeated its warnings this week as it wrapped up its consultations with European officials, whilst US Treasury Secretary Geithner is set to pressure European authorities to carry out tougher stress tests at this week’s G8 meeting.   Germany has taken some steps towards resolving its banking sector problems and this week the German cabinet agreed to support a “bad bank” plan.  Nonetheless, the task will not be easy as Germany is estimated to have over $1 billion in toxic assets, with consolidation of the regionally owned Landesbanken a major concern. 

The prospect of a “V” shaped recovery in Europe is extremely limited.  Warnings about the pace of eurozone economic recovery should be taken seriously.  However, some officials such as the ECB’s Quaden are already talking about an exit strategy, which looks very premature given the likely slower recovery in the eurozone compared to the US over the coming months.  Whilst the US economy is set to see positive growth next year, albeit below trend, Europe is facing a second year of economic contraction.   Moreover, the drop in Eurozone growth in 2009 is likely to be far steeper than the US, with the economy set to decline by close to 5%.  The bigger than forecast 21.6% annual drop in German industrial production in April and the 29% annual drop in April exports released this week provided a timely reminder of the pressure on Eurozone’s biggest economy.  Given the fact that the German economy is still highly reliant on export growth the data were particularly worrying. 

Against this background and with inflation continuing to drop, the ECB is highly unlikely to raise interest rates until the beginning of 2011 at the earliest.  The fact that ECB officials are even talking about an exit strategy seems completely at odds with the reality of the situation.  As it is the ECB’s EUR 60 billion covered bond purchase plan will have a limited impact, and the policy can hardly be labeled as aggressive.  

Even so, there is no indication that the ECB is about to embark on more aggressive credit or quantitative easing.   The latest ECB monthly report predicts that growth in the eurozone will begin to pick up by the middle of next year but admits that inflation could turn negative over coming months.   Surely this will give the ECB further room to maintain easy monetary policy.   Once again disagreements within a 16 nation ECB council will result in compromise at a time when the eurozone economy is crying out for decisive policy actions.   Growth and banking sector concerns will also be a factor that helps to prevent the euro from fully capitalising on any weakness in the dollar.

Posted in central banks, Economics, Economy, Europe, Financial crisis, Germany, Interest rates, Monetary Policy. Tags: , , , , , , , , , , , , , , , , , , . 4 Comments »

Are foreign investors really turning away from US debt?

May 29, 2009 — Mitul Kotecha

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, Europe, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , . 5 Comments »

Europe to recover at a snail’s pace

May 26, 2009 — Mitul Kotecha

There have been two pieces of data released over recent days which give us a good idea of the state of Europe’s biggest economy, Germany. The IFO survey – a crucial gauge of business confidence and an important forward looking indicator for the German economy, if not the whole eurozone economy – increased in May for the second straight month but came in lower than forecast. The second was the final reading of first quarter GDP, which confirmed the very steep 3.8% quarterly decline in growth, fuelled in large part by weaker exports.

Of course any improvement is encouraging but the fact that the rise in the IFO was less than expected highlights that the market has moved from excessive pessimism to being overly optimistic about recovery prospects. Moreover, at current levels the IFO remains at historically lows and still consistent with economic contraction. Admittedly it is at least consistent with a smaller pace of contraction in the economy in the months ahead but still way off indicating actual economic expansion.

The problem for Germany as highlighted by the GDP data is that the economy remains highly export dependent and given that global trade continues to shrink it points to very difficult times ahead. Moreover, the likelihood of a much bigger increase in unemployment and ongoing problems in the financial sector, points to the outlook for the consumer remaining very tough indeed for a long time to come.

Financial sector problems will only delay recovery.  A report in the UK’s Telegraph even carries a warning from the German bank regulator that toxic debts at German banks could blow up “like a grenade”. I won’t spend any more time on toxic debts at European banks but suggest reading a previous post titled “Stress testing European and UK banks” ,that highlights the lack of transparency and potential for much more writedowns in the months to come.

The problem is not just a German one. The eurozone economy is likely to recover much more slowly than the US despite the fact that the US was at the epicenter of the crisis. The major difference is that policy in the US is far more aggressive and rapid compared to Europe. European policymakers have struggled to put together any form of co-ordinated policy response and there is still an unwillingness from Germany to enact a fiscal stimulus package despite the fact the economy has weakened more rapidly than many other countries.

Moreover, conflict within the European Central Bank (ECB) council means that an aggressive move towards quantitative easing appears highly unlikely. The latest measure by the ECB to purchase EUR 60 billion in covered bonds hardly registered with markets. Faced with many opposing views from within the ECB representing many different countries this situation is unlikely to change anytime soon. As a result, Europe is destined for a snail’s pace of recovery, which could also stall the appreciation of the euro in the month ahead.

Posted in bank rescue, central banks, Economics, Economy, Europe, Financial crisis, Germany, Politics, US. Tags: , , , , , , , , , , , , , , , . 1 Comment »

Not all doom and gloom in the UK

May 6, 2009 — Mitul Kotecha

There is a particularly depressing headline in the UK Telegraph stating that Britons will have to work until the age of 70 to bring public debt under control.  The NIESR who made the prediction believes that the UK will have to take drastic measures such as raising the retirement age, drastically raising taxes, and/or sharply cutting spending to reduce the debt burden in the wake of government borrowing plans amounting to £175 billion (see A taxing time in the UK).  

All of these look unpalatable but there is little choice otherwise future generations will have to pay a heavy price and/or investor demand for government debt could collapse.   At the same time the NIESR forecasts that the UK economy will drop by a whopping 4.3% this year, which is more pessimistic than government forecasts.   

The size of the debt burden is clearly distressing but by now most of us have likely got over the shock of the budget announcements.  Although the issue will not go away quickly attention is turning to some positive signs emerging in the UK economy and the housing market.  For instance, amidst the gloom of the NIESR predictions they also forecast that the economy will begin to grow again in the fourth quarter of this year.   

There was also a separate report just released showing that UK consumer confidence rose the most in close to 2-years according to the Nationwide.  Importantly, the gauge of future expectations rose sharply, suggesting a recovery in the months ahead.  Added to evidence that mortgage approvals have risen to a 10-month high, whilst manufacturing and service sector confidence have improved, it looks as though the economy and the housing market are finally beginning to bottom out.    

All of this will take some of the pressure off the Bank of England but it does not mean that the BoE’s £75 billion asset purchase plan will be scaled back any time soon.   Moreover, interest rates are likely to remain on hold at the low level of 0.50% for several months to come, which in turn is good news for consumers and borrowers alike.   So, perhaps its time to shake off the gloom and look ahead as the worst for the beleaguered consumer has likely passed.

Posted in central banks, Economics, UK. Tags: , , , , , , . 2 Comments »
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