What the G8 communiqué didn’t say

June 15, 2009 — Mitul Kotecha

There was a stark contrast between the outcome of the weekend’s G8 meeting in Lecce, Italy, and April’s G20 summit in London.  For a start, the tone was far more positive than in London, with Finance Minsters attending the meeting indicating that economic forecasts may need to be revised upwards rather than the steady stream of downward revisions seen over recent months.

The overall tone was one of cautious optimism.  The communiqué noted “there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence”.  However, at the behest of the UK the comments “but the situation remains uncertain and significant risks remain to economic and financial stability” was inserted into the final communiqué.   Such an inclusion is logical and at least suggests that officials are not getting to carried away with the improvement in recent data. 

Officials also began discussing “exit strategies” in terms of withdrawing massive global monetary and fiscal stimulus and even requested the IMF look at the issue in more detail.  Whilst it is premature to even discuss exit strategies the comments were clearly aimed at easing bond market concerns about widening fiscal deficits and inflation risks.  As Tim Geithner highlighted, recovery would be stronger if “if we make clear today how we get back to fiscal sustainability when the storm has fully passed”.   Nonetheless, a mere discussion about exit strategy is highly unlikely to remove the current angst that has built up in bond markets globally. 

Additionally, the communiqué included a commitment to develop standards governing the conduct of international business and finance, international regulatory reform, exchange of information for tax purposes and a commitment to refrain from protectionism.   None of these points will move markets this week and all were unsurprising discussion points. 

So what was missing?  The issue of stress tests on European banks was left out of the final communiqué even though it was discussed at the meeting. Reported disagreements with Germany and France over transparency over the publication of stress test results meant that an agreement could not be reached.  This is a big disappointment.  I have written about the issue in two previous posts “European economy in a whole lot of trouble” and “Stress testing European and UK banks” on my blog Econometer.   The fact that more wasn’t done will mean that uncertainty about the health of balance sheets in particular of banks in Germany will remain a constraint to European recovery.  At the least it will make it increasingly likely that in addition to a sharp decline in European growth this year GDP could also drop in 2010.

In addition, economic data continues to lag in the Eurozone compared to the improving signs in the US and elsewhere as highlighted by the huge 21% annual drop in April Eurozone industrial production at the end of last week.  This data even led to another omission with reference to “encouraging figures in the manufacturing sector” previously included in the draft dropped in the final communiqué.   It is clearly too early to talk about manufacturing recovery.

Also missing in the final communiqué was any reference to currencies. Although it was always unlikely that FX would be a major topic at the meeting due to the absence of central bankers attending, the drop in the dollar and concerns from foreign official investors (see a recent post on my blog “Are foreign investors really turning away from US debt”) raised the prospect that there would be some international backing of the US “strong dollar” policy led by the US. 

In the event there wasn’t any comment, but dollar positive comments on the sidelines of the meeting will likely limit any pressure on the dollar this week.  The dollar will be helped by comments on the sidelines of the G8 meeting as well as important comments from Russian Finance Minister Kudrin who stated that he has full confidence in the dollar with no immediate plans to move to a new reserve currency. Ahead of the meeting of BRIC countries this week the comments from Russia add further evidence that there will be no plan to move away from the dollar. Moreover, geopolitical tensions including the protests over the results of Iran’s elections as well as more jawboning from North Korea will work in favour of the dollar this week. 

The euro could look especially vulnerable this week. The lack of attention on European banks stress tests will be a disappointment for those hoping for more transparency and will act as a further drag on the euro.  This is likely to see the euro struggle to make much headway this week, with the recent high above 1.43 likely to provide tough resistance to any move higher in EUR/USD, with a bigger risk of a pull back towards the 1.37-1.38 levels.

Posted in bank rescue, Bond markets, central banks, Currencies, Economics, Economy, Europe, Financial crisis, Germany, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

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 »

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 »

Will India remain in the shadows?

May 18, 2009 — Mitul Kotecha

Indian markets rejoiced in a big way following the outcome of the elections which put the secular Congress party back into power as the head of the United Progressive Alliance.   Stocks in India rose by a massive 17% and the rupee strengthened as markets gave a huge thumbs up to the outcome.   The margin of victory was bigger than had been expected and allows Congress to form a government with only minimal help from outside parties.  

Given that many had feared that the election would result in another unstable coalition supported by diverse parties each acting in their own interests,  the outcome was very positive.  In the event the result provides Congress with a strong mandate for change and reform.  The real question is whether they will grasp the opportunity or let it slip by and fall further behind into the shadow of China. 

There are of course many challenges that need to be faced on the home front including the alleviation of poverty for a huge chunk of the population, improving education, access to health care etc.   India also needs to move ahead with infrastructure spending, something which remains key to unlocking India’s potential growth and moving towards the pace of growth achieved by China.    As a comparison India spends around 6% of GDP on infrastructure spending compared to around 15% in China.   The results of such spending are obvious when looking at the pace of growth of both countries, with India growing relatively more slowly than China.

The issue is that even if the government has the mandate and the will to move forward with long awaited spending on infrastrucure, finding the money is the main problem.   The Indian government identified the need for $500 billion in infrastructure spending between 2007 and 2012 but the global financial crisis has seen a lot of potential investment disappear as banks bec0me increasingly strapped for cash and foreign investment shrinks due to lack of funding and an aversion to risk.   Restrictions on investments by funds that could potentially invest have also not helped whilst the government is limited in its spending by a huge fiscal deficit.    

The Congress party will need to grasp the opportunity that the election result has brought it and move forward to entice the investment needed to push forward with infrastructure plans.   One of the benefits of India’s slow pace of reform and gradual opening up of the economy is that the country has avoided the worst of the global economic crisis.  Even China will find it a huge challenge to shift its growth engine from export orientated growth to domestic consumption.  India is in a good position to take advantage of its relative resilience and now has a government with a strong mandate to do so.    It would be a great pity for India and the rest of the world, given the potential for the country to become a much stronger trading power, if the government did not take this opportunity by the horns once the celebrations are over.   If not, the rally in Indian markets may prove to have been a fleeting one.

Posted in Asia, China, Currencies, Economics, Economy, equity markets, Financial crisis, India, Indian election, Politics. Tags: , , , , , , , , , , , . Leave a Comment »
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