Friday, July 18, 2008

What Is The Risk Of A Serious Melt-Down In The Spanish Economy?

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again
John Maynard Keynes

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking this week to Spanish radio station Punto Radio

Jose Luis Borges tells a story about two rascally villains, eternal rivals, who - under sentence of death - are offered one last bet: rather than accepting a conventional execution they can agree to have their throats slit simultaneously, just to see who is a able to run the farthest. Immortality, rather than fame, in an instant. Now I mention this since tale I can readily anticipate the immediate feelings many will have on reading what follows (I am at the end of the day going to argue that it is necessary to inject money - and I do mean rather a lot of money - into a banking and construction system which many will want to argue is largely responsible for Spain's present distress, and indeed, that having made a good deal of money out of the operation, these are the very people who should now be forced to don that sackcloth and ashes costume which so behoves them (actually the way things stand they are much more likely to find themselves reduced to a sporting a loincloth, but still). I understand why many ordinary Spanish people may have such feeling, but I do think this is a time for cool heads, and that what is most needed here is an extreme dose of pragmatism coupled with a lot of emotional intelligence. There is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

Martinsa Fadesa The First To Go

This week's filing by the Spanish property developer Martinsa-Fadesa for protection from its creditors has brought Spain's ongoing economic agony back to the headlines. The decision follows a request from Martinsa Fadesa last Friday to its creditor banks for a postponement of the deadline on their requirement that the company obtain a 150 million euro ($235.7 million) loan. The banks refused the request and the rest is now, as they say, history. The failure of Martinsa - Fadesa whose debts are in the region of 5 billion euros - is not only the largest corporate bankruptcy in Spanish history, it is also a reflection of the pain which must now be being felt in Spain's troubled banking and construction sectors, and a harbinger of what is, in all probability, going to be much worse to come.

Spain At Risk

So to come directly to the matter which has provided me with the header to this post, just what is the risk that the present recession in Spain is something a bit more than a mere recession? What is the risk of a real and serious economic melt down just across France's Southern border, a mere stone's throw away (by plane) from Brussels or Frankfurt, yet still on the other side of that intellectual and cultural divide which seems to be formed by that ever so picturesque natural barrier known as the Pyrennees? Well it is a non-negligable one, in my view. Let me explain a bit.

First, as background it would be worth reading my Artemio Cruz Syndrome post, since all the main macroeconomic arguments are presented there (and those who seriously want to know what is going on should definitely read the excellent "Spain:Bubble Bursting - We now expect a full-blown recession" desknote from PNB Paribas).

Secondly, we need a bit of vocabulary clarification, since the terminology being used has become somewhat confusing of late. We could reasonably break things down as follows I think:

i) Soft Landing
ii) Hard Landing
iii) Melt Down

Now, in terms of the available semantic space, why don't we allow that "soft landing" means a recession of the more or less garden variety (as Portugal or Italy have at this moment, or as say France may anticipate, or Denmark) and not consider this to mean avoiding recession completely, which is how some seem to have used the term in recent times (I think it is hard to imagine any EU 15 economy avoiding recession completely between now and Q2 2009). Possibly Hungary up to this point could also be said to have had a comparatively soft landing.

"Hard Landing", on the other hand would be what they are currently experiencing over in the Baltics, what they may well soon experience in Romania, Bulgaria, the UK, and Ireland, and what is now most certainly taking place in Spain. Thus by "hard landing" I mean a very sharp slowdown in growth, a medium sized contraction in consumption, financial distress and bankruptcy in some areas, and a recession which drags itself on for more than a mere two quarters (in and out of negative growth) and probably results in annualised negative growth for a period of at least 12 consecutive months. What happened in Turkey in 2000 was certainly a hard landing in this sense.

iii) "Melt Down", following such definitions, would then be a Hard Landing plus, a Hard Landing plus a shock (or in Hungary's case, where the shock would be a run on the forint, you could imagine what initially is only a Soft Landing being converted into a melt down, but arguably Hungary's case is very special given the very high level of exposure of household balance sheets to CHF denominated forex loans).

Such a shock could be a banking crisis, a run on the currency, a sovereign default (this is where Italy's series of perpetual soft landings could move decisively into meltdown mode one of these fine days if something isn't done to correct the low growth/high sovereign debt to GDP dynamic while there is still time).

Now in this sense, Spain's economy is at some significant level in danger of having a melt down - lets define this as more than two years of negative GDP growth with a magnitude of more than one percentage point, coupled with (in the case of countries which have their own currency) very sharp devaluations, and in the case of those that don't severe and extended price deflation (ie a mini version of what happened in the USA in 1930).

Now the recession in Spain is, I think, more or less most certainly already served. The Spanish press were talking earlier in the week about a quarter on quarter contraction of 0.3% in Q2, and it is hard to see any acceleration of the economy in Q3. Pedro Solbes, when questioned explicitly by Punto Radio on the possibility that whole year growth for 2008 could turn negative replied diplomatically "It's not my feeling at the moment", which means basically that it might well turn out to be the case.

If this expectation if fulfilled then Paribas may have to revise their latest forecast slightly (see above link) since - in what is really an excellent general analysis - they pencil-in the recession to start in Q3 2008 and then move on to anticipate a contraction in the Spanish economy of 0.75% in 2009 (although as they freely admit all the risks here are skewed to the downside). My own personal call at this point is that the recession may well have started in Q2 (we will soon know) and that the contraction in whole year 2009 will be over 1 percentage point. Further than that I am not willing to go at this stage, since it all depends, and in particular it depends on whether or not we get a nasty "event" or series of events which send the economy hurtling out of the "hard landing" bracket and into the "melt down" one. It is because I strongly believe we be should doing everything we possibly can to avoid that eventuality that (and not continue to languish under our blankets with a heavy dose of the Artemio Cruz syndrome) that I am writing this post now.

Before continuing, however, I should point out that even the Paribas idea of negative growth in 2009 is still very nonconsensual, despite the widespread pessimism which currently surrounds the Spanish economy. The consensus economic survey for June gives a median 2009 growth forecast of 1.5%. The lowest forecast in the survey is 0.4% but most are grouped in the range 1.0-1.8%. Maybe the consensus will catch up with the curve in due course.

Structural Unwind

So what would be my justification for making such an apparently gloomy forecast? Well as I argue in my Artemio Cruz piece, and as Paribas re-iterate in their study, this is no ordinary crisis. It is taking place against a background of a severe credit crunch which affects the entire financial sector, in a country with an enormous external deficit (CA deficit over 1o% of GDP and rising), which has a strong external energy dependence, and at a time when food and energy prices have been rising sharply. All of this is bound to exert a very strong downward pressure on internal consumer demand, and as a knock-on impact on investment spending. At the same time slowing growth globally, and in the EU and eurozone economies in particular, makes for a very difficult external environment where increasing exports (even assuming Spanish export prices were currently competitive, which they aren't) becomes difficult, if not well nigh impossible.

Serious Structural Distortions

So let's take a quick look at some of the underlying structural issues. In the first place both Spanish households and corporates are extremely highly leveraged at this point in terms of their outstanding debt obligations. The levels of debt to GDP are really extraordinarily high when compared with their eurozone peers.

So how did Spain get into this rather precarious situation? Well I don't think you need to look too far to discover the answer. As can be seen in the chart below, Spain effectively had negative interest rates throughout the entire period between the start of 2002 and the autumn of 2006. That this state of affairs was produced in the very earliest years of the history of the eurozone was indeed, in my opinion, truly unfortunate, since it meant that inflation expectations had not had time to be "steered down" by a central bank track record. Thus a very widespread reaction on the part of ordinary Spaniards to what were generally perceived to be derisory interest rates for savers was to withdraw money from longer term deposit accounts and to place it in what was considered to be the safest of safe inflation hedges: property. Thus began what may well turn out to have been one of the most serious property bubbles in recent history.

The situation was also doubly unfortunate, since the ECB along with other central banks had lowered interest rates in an attempt to support economic weakness produced by a drop in stock market values following the collapse of the internet boom. In Spain's case however, the excesses caused by the internet boom never really had the opportunity to unwind, since as one boom ended, another one simply got going in its place. This effect can be clearly seen in the chart for long term quarterly GDP growth produced below, where we can see that following the 1992/93 recession (and up to Q2 2008) Spain simply hasn't had one single quarter of negative growth - that is during 15 years. Hence the legend of the Spanish economic miracle was born. But as with all legends, we should also really be asking ourselves what the reality was which lay behind it, since as we can now see, the absence of recession - and in particular the absence of recession in 2002/03 - simply means that we now have a lot of extra "distortion" lying out there and waiting to be "corrected" (the waste-pipes were effectively never flushed, which is why we are now faced with such a peculiar smell emmanating from the sewage system). This would be the main reason why I would argue that what we cannot now expect is a relatively smooth "return to trend" in 12 to 18 months time, since Spain has effectively been "off trend" for some six or seven years now, and the magnitude of the excesses (10%+ CA deficit, 5 million immigrants in eight years, corporate indebtedness pushing the 120% of GDP mark etc etc) is prima facie evidence for this. So even in the best of cases we are almost certainly now facing a significant period of negative and then very low headline GDP growth. But we may not be lucky enough to get away from all this with a simple best case scenario.

The last piece of structural evidence I would offer in this post refers to the CA deficit situation. Since I deal with that reasonably exhaustively in the Artemio Cruz piece, I will only refer to one item here: the deteriorating balance on the income account.

Now this is important in my opinion. It is important since obviously any of the remedies to Spain's short term financing problems imply borrowing money (in some way, shape or form via the support which is offered by belonging to the eurosystem). Spain needs one of those proverbial "bailouts", even though since Spain does not have its own idependent currency this position is somewhat masked by the fact that everything is denominated in euros. But debts incur interest, and the more you borrow, the more you effectively have to pay, not only in capital, but also in interest. And if Spain country risk rises sharply in any way - as some analysts are suggesting it may have to - well then what is already a serious problem is only going to become a more serious one.

Land Prices

So where are the risks? Well I think it is no simple accident that Martinsa-Fadesa has been the first major developer to go, since a very large part of their portfolio is composed of land. According to press reports Martinsa Fadesa had land totalling 28.67 million square metres, 41 percent of which is outside Spain (and 50% of which is not "zoned", that is it is without the necessary premission to build). They also have a stock of more than 173,000 newly-built and unsold properties (again by no means all of these are in Spain). Now land is going to be a very important component in this whole "correction", since a lot of land (as we can see) has been accumulated with intent to build, and much of this land may now become virtually worthless. And land prices are already falling faster than house prices. Data from the Ministry of Housing shows that land for building fell to 251 Euros/m2 in March, a 7.7% drop when compared with March 2007. Land prices had fallen for 3 consecutive months by March with the average cost of land in Spain now being back somewhere around where it was at the end of 2004.

So I would say this is one of the first issues the Spanish government needs to tackle, and quite urgently. Frankly I can see little alternative to having the government intervene and take this land off the books of those who are holding it - not at market prices, they can handle some sort of "haircut" - but I don't think the government should be sitting idly back and watch one developer after another simply fold, since the end result of this is that the problem then moves over into an already overstretched banking sector.

Which brings me to my exhibit one: Japan land prices.

One of the key features in Japan's ongoing battle against deflation has been the way in which land prices were simply allowed to fall after the property bubble burst in 1991. The above chart shows the sharp rise in Japanese land prices from 1986 to 1990 - a period during which they more than doubled - and how they subsequently fell - albeit more gradually — by roughly two thirds from 1990-91 to 2005. Although urban land prices started to turn up slightly post 2006, land prices still continue to fall elsewhere, and of course we still haven't seen how the latest construction "bust" in Japan is going to leave things. Unsurprisingly, residential construction has remained virtually dormant in Japan over this entire deflationary period.So the question is, what is to stop this happening in Spain. I would be grateful to anyone who can present me with a reasoned argument as to why what happened in Japan won't happen here. Meanwhile the risk is evidently there.

The Builders In General

Obviously even if the most immediate and pressing problem in Spain is arising in the area of land prices, the rest of the housing related construction sector will not be far behind. This is a problem that is simply waiting to happen. According to the latest data from the Spanish housing ministry, average Spanish property prices fell by 0.3% in the 3 months to the end of June, but they were still 2% up on prices in Q2 2007, a factor which is leading many to question the reliability of the Spanish data (one more time Artemio Cruz strikes, since Spanish institutions are far from swift in responding to problems, and would seem to prefer denying that they exist). One explanation for the present situation may be that prices are being measured in terms of the initial asking price and not the final selling price. Whatever the explanation prices are certainly set to tumble, and even the the G-14 developers’ association, traditionally a staunch upholder of the immobility of property values, has had to admit that new-build prices have fallen by 15% in the last 6 months alone, while Cue Mariano Miguel, ex-president and present board member of the much troubled developer Colonial, is already predicting a fall in the region of 25% to 30% over the next two years. And new property in Barcelona (which is where I live) is now taking ten times longer to sell than it was only a year ago, according to real estate consultancy Aguirre Newman.

Meanwhile we learn from Jose Luis Malo de Molina, director general at the Bank of Spain (speaking at a recent conference in Valencia) that the number of new homes which will be completed in Spain in 2008 will beat all previous records (I said this was a system which was slow to react), simply piling one more house after another in order to add to that glut of newly completed homes that is already idly languishing and casting its long shadow over the Spanish property market. Muñoz's explanation for this phenomenon is simply that “the real estate sector can’t turn around quickly, it works in the medium and long term, so this year the properties started at the end of 2005 and beginning of 2006 will be completed, which means the number of new properties on the market will hit an all time high.” As I say, "just in time" may be an idea that has entered the heads of the more agile companies like the textile consortium Inditex, but most of Spain is a very, very long way from being able to offer an agile response. On the anecdotal front, a friend of mine recently went to visit family homes in the North West of Spain. In Vigo he spoke to the owner of a brick factory, and in Leon someone who had a quarry. In both cases production was continuing (there is simply no on/off switch here) but the inventory already had piled up to the extent of being now prepared to satisfy normal requirements for the whole of 2009 (in both cases), and of course, in 2009 requirements will not be normal, since housing starts in 2008 have collapsed to a forecast of below 200,000 (down from 600,000 plus in 2007).

At this point estimating the volume of unsold housing in Spain is really a question of "its anyone's guess" rather than a matter of scientific fact. The number 1 million is popular, but I suspect this is more a question of serving up an easily managed factoid than one of accurately measuring empty houses one by one. The same applies to the estimates for the size of the likely fall in property values. All we can safely say at this point, I think, is that the number in both cases is large.

The big question for our current concerns is who is exposed to the risk on all this, and the answer to that question is a lot simpler: Spain's already cash-strapped banking system.

One common estimate of the exposure of the banks to the builders would be somthing of the order of 300 billion euros - this is the opinion of Spanish analyst Inigo Vega at Iberian Securities (and it is one I more or less share). So we could say we have something in the region of 20% to 25% (or more) of Spanish annual GDP in play here.

Bank Exposure Through Mortgage Backed Securites

To this second order exposure of the banking system to the construction sector alone (and remember, through the negative impact of all this on the real economy, we should never lose sight of those non-construction corporates, you remember, the ones who had all that indebtedness we saw in the first chart) we need to add the exposure of the banks to the cedulas hipotecarias, which alone run to something in the 250 to 300 billion euro range (to which we need to add, of course, other classes of more conventional mortgage backed-securities ). If we add these two together - the builders and the cedulas - then we are obviously talking about a potential injection into something of over half of one years GDP in Spain.

According to Celine Choulet of PNB Paribas mortgage-backed securities in the broader sense of the term (ie including cedulas and MBS) now add up to around 37% of outstanding mortgage loans in Spain. She also estimates that asset backed securities held by non-residents may amount to as much as 81% of the total securities issued.

Outstanding home loans (for purchases and refis) represent a substantial percentage of the Spanish banking institutions’ balance sheets (21.5% of total assets and 35.6% of total loans to the non-financial private sector in the second quarter of 2007). In the second quarter of 2007, outstanding home loans amounted to 589 billion euros, 56.4% of which were distributed by cajas (29.8% of their assets), 37.2% by commercial banks (15.4%) and 6.4% by mutual institutions (30.9%).

If we add together home loans and the financing of real estate sector (construction and property services), the overall exposure of Spanish credit institutions has increased significantly over the last decade (37% of assets in the second quarter of 2007, 61.5% of total loans to the non-financial private sector). Exposure of Spanish banks to the real estate sector has exceeded, both in level and in growth rate, that of US, Japanese and British banks. In total, in the second quarter of 2007, cajas (49.7% of assets, 70.5% of loans) and mutual institutions (46% and 56.3% respectively) were almost twice as exposed as commercial banks (28% and 55.2% respectively).

According to Choulet - and just to take one example - in 2006 total new funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).

And remember the cedulas all need to be "rolled over" in the next few years (with a big chunk coming up between now and 2012). And the problem starts this autumn. According to an article in the Spanish daily El Pais at the end of June the Spanish banking sector needs to raise 62 billion Euros before the end of this year just to rollover what they have coming up on the immediate horizon.

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous. Banco Popular is the most visible sign of the pressure, and their shares have already dropped by 44% this year, and by 7.9% on Tuesday alone (they were the listed bank which was most exposed to Mrtinsa Fadesa).

So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough. Yet, cor blimey, we are still busying ourselves arguing about the small print on the Lisbon Treaty.

Demographics and Construction

The third major area of risk I would like to highlight today relates to the problem of demographics and their impact on the construction outlook. PNB Paribas (see initial link) see demography as one of the principal downside risks to their forecast. They put it like this:

"With United Nations population projections pointing to growth of only 300k per year on a ‘high-population’ variant for 2010-15, housing starts could fall considerably further. Hence the risks to our central forecast of 30% off housing investment by end-2009 are to the downside. The correction could be more rapid than expected. If not, it is likely to persist into 2010. ...........Our forecast has housing investment converging to levels consistent with relatively strong population growth. A weaker population assumption or some undershoot of the ‘equilibrium’ level would lead to a worse outcome."

Basically, I think the big topic in this context is the coming rate of new household formation. And here it is worth remembering that while the countries most affected by the property-driven credit crunch in the EU would appear to be Spain, Ireland and the UK, the UK is rather different from the other two, since while housebuilding grew by 187% in Spain between 1996 and 2006 (and by 177% in Ireland), the equivalent increase in the UK was just 12%. Planning restrictions in Britain meant fewer homes were built and the resulting relative scarcity may provide one part of the explanation for why house prices have almost doubled, in real terms, in the UK since 1999 despite the comparatively low percentage of new builds (this would bring us back to the huge zoned and un-zoned lang overhang in Spain, and what the dynamics are that produced it). That is, while the UK can to some extent offset the impact of the crisis in the longer term by increasing homebuilding (to house, for example, all those extra people from Poland and other parts of Eastern Europe), in Spain and Ireland the problem is going to be very different, since they both have to sharply reduce housebuilding capacity.

So what are the main sources of new household formation in Spain? Well basically they are threefold: natural population development, migration, and second homeowners from the north of Europe. Now if we start with the question of natural population evolution in Spain, ex-migration the Spanish population is virtually stationary at this point - with an average annual increase of a mere 30,000. But what matters in housing terms is not so much the size of the population as its age structure, and here we don't need to go to the level of refinement involved in looking at longer term UN population projections (high, median or otherwise) because in terms of Spanish property from now to 2020 (at least in terms of natural population drift) the deal is now done (or rather the goose is now cooked), and a quick glance at the US Census Bureau IDB population pyramid for 2000 should make this abundantly clear (see below).

What we can effectively see is that in 2000 (and please click on the image if you want a better look) Spain's three historically largest 5 year cohorts constituted the 25 to 40 age group. But if we mentally fast forward as far as 2015 we will see that the aggregate size of the cohorts in this age range is very significantly smaller, and if we fast forward again to 2020, we will see that what we have are the three smallest cohorts in the last forty years. And from here on in we only go down and down - talk about absence of sustainability!

So we are left with North Europeans is search of second homes and migrants to offer some support to Spain's rapidly crumbling housing sector in the coming years. Well on the North Europeans front the picture doesn't look exactly promising either, since the bulk of the buyers in recent years have been British (Britons own an estimated 500,000 to 700,000 properties in Spain), and they are already having their own problems, plus the fact that changes in the value of the GBP and interest rates mean that affordability is becoming an issue, an issue to which you have to add the drop in attraction of properties whose prices may now be set to seriously deflate, and over a significant number of years.

Indeed, according to Manuel Gandarias, president of the ‘Live in Spain’ holiday-home developers’ association, sales of holiday homes in Spain are now down by 50% from the peak “In recent years between 120,000 and 125,000 holiday homes were sold each year, this year it will be half that,” he is quoted as saying. And of course it isn't only the cost of buying the home that has been going up, it is also the cost of servicing the debt that buying the home brings with it. Josep Suárez, director at Solbank in London estimates that the combined impact of rising Euribor rates and the appreciation of the Euro against the pound (15% in the last 9 months) means that mortgage payments for Britons with mortgages in Spain are now 25% higher than they were a year ago.

So the outlook on the North European second home market doesn't exactly look bright either, which leaves us with the migrants. As is now generally well known, Spain's population has increased dramatically in recent years - from around 40 million in 2000 to around 45 million in 2008 - and this increase has been almost exclusively (natural increase is no more than a quarter of a million) the result of huge inward migration.

Basically the future of all these migrants is now deeply uncertain. I would even say that losing the migrants constitutes the most important of all the downside risks to the Spanish economic crisis for the impact it will have on urban rents and mortgage delinquency in the short term (since many of the migrants have bought flats), and for the consequences for Spain's housing market and pensions system in the mid term. Evidently, since most of the migrants are economic migrants the inward flow must surely be about to dry up (since there are few if any jobs for them) and thus our attention should be focused on the need to hold onto those we already have.

Is There A Rescue Plan Available?

Basically, and on the basis of all the above, I would like to now put forward a five point "rescue" plan for the Spanish economy. It would look something like this:

1/ Set up a national land agency, to buy up land and to irrevocably convert it to other uses (agriculture wouldn't be a bad bet where possible given present food prices). This to include the proviso that such land could never again be zoned.
2/ Buy out and close down the bankrupt builders as part of a general restructuring programme such as the one which was developed for the shipyards and the mines.
3/ Buy up and burn immediately ALL outstanding cedulas hipotecarias. Well, I'm exaggerating here, but something very decisive needs to be done to take these things out of circulation in the longer term, or we will never ease Spain out from under this.
4/ Establish a programme to help immigrants in difficult circumstances, and offer training etc to prepare for the future. Abasic focus of policy needs to be on trying to persuade migrants to stay.
5/ Restructure all existing mortgage contracts - which will involve every one paying more - in order to put mortgage financing in Spain back on a sound footing. This will obviously require legislative intervention, and will equally obviously involve breaking the direct tie with one year euribor. It has been following euribor up and down which has gotten the Spanish mortgage market into this mess in the first place.

OK, I warned you. I said none of this was going to be popular. And none of these propsals should be consider as carved in stone. Better ones could well, I am sure, be put forward, but in the absence of anything credible in the way of alternatives I am putting them forward now. As I said at the start, there is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

It is very, very important that some form of "corta fuegos" (fire break) is put in place, and put in place now, otherwise the whole of Spain could very easily burn down in just the same way the Liceu opera house did here in Barcelona, simply because some chump decided to do on-stage soldering repairs with the safety curtain up! Risk sir, there's no risk here. It's all as safe as houses.

Wednesday, July 16, 2008

Some Graphs On Spain

Another measure of Japan’s deflationary hangover is how long land prices continue(d) to fall after the property bubble burst in 1991. Figure 2 shows the sharp rise in Japanese land prices from 1986 to 1990 when they more than doubled, and then fell by two-thirds albeit more gradually—from 1990-91 through 2005. Although urban land prices turned up slightly in 2006, land prices continue to fall elsewhere. Unsurprisingly, residential construction remained virtually dormant over this deflationary period.

Sunday, July 6, 2008

What Is The Recession Risk For The German Economy?

Christian Menegatti in his Global Recession Watch post on RGE Monitor last week strang together an impressive list of countries which might be at risk of entering recession during 2008. One name which was conspicuously absent from the list was that of Germany. Yet the situation here is not as self evident as some may assume, and one of the aims of this post is to pose the question: just how realistic it is to expect an export dependent German economy to avoid recession when so many of its most important customers - the UK, the US, Spain, Italy... - are either skirting or entering recession even as I write? Indeed Sebastain Dullien implicitly asks this same question in his most recent post here on Europe EconMonitor.

As Sebastian points out there are now a growing number of indicators which suggest that the German economy is not only slowing, but slowing comparatively rapidly. And maybe one indicator here says it all: industrial output. Increasing industrial output to fuel rapid growth in export demand has been at the heart of Germany's most recent expansion, and, as can be seen from the seasonally adjusted output index in the chart below, industrial output has now been declining for three consecutive months (as of May data, released 07/07/2008).

In addition all the main sentiment indicators are now down (including the EU Composite Economic Sentiment Indicator, which came in at 101.5 in June, its lowest level since January 2006). The latest Ifo institute business climate index fell to 101.3 in June (again its lowest level since January 2006) down from 103.5 in May, and the Sentix institute index (released this morning) fell to minus 9.3 from a positive 5.2 in June. That's the lowest since June 2005 and the biggest one-month drop since the start of the index in February 2001.

The GFK consumer confidence index was also down this month, with the forward looking index for July dropping to 3.9 from a revised 4.7 in June. Again this is the lowest reading in quite some time. In particular in their monthly report GFK highlighted how continuing high inflation was eroding income expectations and the consumer propensity to buy. According to the latest flash estimate from the German federal statistics office, inflation is thought to have hit 3.3% annually in June, and if confirmed this will be the largest price increase since December 1993.

German manufacturing orders declined in May, the sixth straight month that orders have been down. Orders, adjusted for seasonal changes and inflation, fell 0.9 percent from April, according to data from the Economy Ministry last week.

And The Real Economy Is Faltering

So much for the sentiment indexes, but what about the real economy? Well if we look at retail sales these were up by 0.7% in real terms in May over May 2007. However, if we look at a longer term time series, we can see that, despite the comparatively positive general economic environment, sales have not been strong for some time now, and in fact they have only registered monthly year on year increases five times since January 2007.

Despite the fact that May saw quite a sharp increse over April - 1.3% in real terms m-o-m sales seem to have contracted again markedly in June according to the last Bloomberg retail PMI reading. The index slumped from May's eighteen-month high of 56.6 to the low level of 44.9 (remember that on the PMIs 50 marks the neutral point, with readings over that level indicating expansion, and below contraction. Looked at this way it would seem sales were contracting almost as fast in June as they were expanding in May).

If we look at the monthly (seasonally adjusted) sales index we find ouselves with a very clear before and after picture, with the sharp pre tax-increase spike in December 2006 being followed by a huge trough in January 2007 following the 3% VAT hike. After that retail sales have never really fully recovered, suggesting that raising consumer taxes may not be as harmless a move as many seem to have thought, and is certainly not the most advisable way to finance the fiscal liabilities presented by population ageing.

If we now turn to industrial production - which, as I say has really been at the heart of the current German expansion - we find that output declined for a third consecutive month in May. Seasonal and inflation adjusted output was down 2.4 percent from April, when it fell 0.2 percent, according to data from the Economy Ministry in Berlin this morning. That is the larges month on month fall since February 1999. Output was up 0.8 percent on May 2007, on a working day adjusted basis.

Manufacturing output was down 2.6% month on month, while construction was up 1% from April, but construction in April was already at a very low level. The seasonally adjusted index peaked in February, and has since been declining, as can be seen in the chart below.

Coming to employment, German unemployment declined in again in June, pushing the jobless rate to its lowest level in almost 16 years. The number of people out of work, adjusted for seasonal changes, fell 38,000 from May to 3.27 million.

And employment is still increasing. There were a total of 40.19 million people employed in Germany in May, an increase of 619,000 (or 1.6%) on May 2007. Compared with April 2008, the number of persons in employment was by 111,000 ( or 0.3%).

Thus the German job creation machine continued to function in May, although at a slightly slower pace than in previous months. From January to March this year, the number of persons in employment each month was by 1.8% higher than in the corresponding month of the previous year, while in April and May 2008 the increase had dropped slightly to 1.6% on April and May 2007. It is too early at this point to decide definitevely whether the current trend can be considered to mark a general slowdown on the labour market. At least part of the slowdown can probably be explained by the fact that the winter months had been unusually employment-friendly because of the mild weather, so that the usual upturn in spring was smaller, although of course this also means that growth in the earlier months of the year was not as stong as appears at first sight.

When looking at the unemployment numbers it is also important to bear in mind that the German labour force is now near its historic peak, and will now steadily decline. An indication of this can be found in the chart below where it can be seen that the rapid growth in the population available for work which characterised the years between 1997 and 2005 has now come to an end, and since 2005 the numbers have been stagnating.

This stagnation in the potential labour force (before an eventual decline if immigration is not leveraged to facilitate growth) is also a reflection of the fact that Gernamy's population is now, slowly but steadly, declining, and has been declining since Q4 2004, as can be seen in the chart below.

The only way to really swim against the stream in these conditions and to continue to achieve sustained GDP growth is by raising labour productivity, but this has been one of the weak spots in the current expansion. Overall labour productivity (price-adjusted gross domestic product per person in employment) rose only very slightly - by 0.1% - in Q1 2008 as compared with a year earlier, although as measured per hour worked, there was an increase by 0.8% (this is because the number of hours worked by those in employment rose much less than the number of persons in employment). The bootom line here is that a lot of the new jobs Germany has been creating are part time and temporary work, often in relatively low value activities.


The core of the German economy, and the principal driver of its GDP growth, is its export sector. Basically, as a crude first approximation, when German exports do well, the German economy grows, and when they don't it falters. In part this is simply the natural corrolary of the fact that German household consumption has remained congenitally weak. The chart below should make this relative co-movement reasonably clear.

Now in April, which is the latest month for which we have data, German exports continued to grow on a year on year basis, led by demand from countries outside the 27-member European Union. Sales abroad, on a seasonal and working day adjusted basis were up 1.2 percent in April over March, when they had fallen back 0.8 percent on February. April exports rose 14 percent on a year on year basis.

One interesting data point is that during the period January to April exports to countries outside the EU increased 11.6 percent from a year earlier (and by 18% April on April) while exports to EU countries rose 5.8% percent, and to the eurozone alone only 4.6%.

If we go back to 2007, which is the last period for which we really have a detailed breakdown of the export data, about three quarters of German exports went to European countries, and 65% went to the member states of the European Union. The second market after Europe was Asia with a share of about 11%, followed closely followed by the United States, with a share of approximately 10%.

So Europe (whether inside the EU or not) is the key to German growth, and this, of course, is one of the reasons why German exports have been so resilient to the rising value of the euro, since (at least until the problems of the property slowdown started to hit the value of the pound sterling) even those coutries who did not share the common currency (like the UK or most of Eastern Europe) had currencies which had by and large appreciated side by side with the euro itself. Of course all of this has now started to change, the UK has its own problems, and inside the eurozone, Spain and Italy are no longer increasing the volume of German products they buy in the way they were even six months ago.

On the other hand, even as some of the traditional customers have begun to falter, new ones have arrived to take their place to some extent, and in particular here new members of the European Union and Russia. To put things in perspective a little, in 2007, and despite all the talk about the "China factor", Germany exported roughly the same quantity of products to the Czech Republic ( 26,026.6 million euro) - population circa 10 million - as it did to China (29,922.7) - population circa 1.3 billion.

A detailed comparison of relative performance between 2006 and 2007 is even more revealing. Of particular interest is, for example, the fact that exports to China only increased by 8.7% in 2007 while exports to the Czech Republic rose at almost double the Chinese rate ( 16.9%). The importance of United States as an export destination, on the other hand, declined, since exports to the US were down from 78 billion euro in 2006 to 73.3 billion euro in 2007, a decrease of 6%. Exports to Poland (another important destination for German exports with 36 billion euro in 2007) were up 25.2%. Spain was also up considerably (as was Italy), rising from 42 billion euro in 2006 to 48 billion euro in 2007 (up 14.2%). The Russian Federation also stands out outside the EU, with exports there rising from 23 billion euro in 2006 to 28 billion euro in 2007, that is an increase of 20.6%. It is clear that the rate of increase of German exports to Russia has accelerated even further during 2008.

Now the list I have just gone through is scarecly a randomly chosen one. The decline in importance of the United States as an export destination for both Germany and Japan - which are the world's No 3 and No2 economies respectively (and both are CA surplus export-driven economies) - surely has some implications for the whole decoupling-recoupling debate.

Also, the dependence of the German economy for exports growth on Poland, the Czech Republic, Russia, Italy and Spain - all of which may find themselves with economic issues in 2008 of greater or lesser importance - is surely more than a minor detail, and the evolution of the east european and latin economies needs to be closely monitored for what they can tell us about the future path of the German one. At this point it is clear that German exports have been labouring in recent months more under the difficulties produced by the slowdown in Spain, Ireland and the UK than they have been suffering the direct consequences of reduced demand in the US.

Q1 2008 GDP

As I reported in detail here, the German economy started 2008 with what seemed on the face of it to be considerable momentum, since on a price, seasonal and calendar adjusted basis gross domestic product (GDP) was up by a very large 1.5% in the first quarter of 2008 over Q4 2007.

Perhaps rather surprisingly, economic growth in the first quarter of 2008 was primarily supported, not by exports, but by gross fixed capital formation. Compared with the fourth quarter of 2007, investment in machinery and equipment was up by 4%, and capital formation in construction by 4.5%. The latter, it has been suggested, being partly the result of a comparatively mild winter. Overall final consumption expenditure increased by 0.5% q-o-q, the first such rise in over a year, however breaking this down we find that government final consumption expenditure was up markedly (+1.3% q-o-q), while the final consumption expenditure of households showed a rather smaller increase (+0.3% q-o-q). But the big "little secret" of the German Q1 2008 data is that inventory levels were up sharply, and inventory building added a substantial 0.7% points (of the 1.5% total) to growth in the first quarter. Obviously this situation is most likely to be corrected in Q2, and this, together with the steady slowing of general economic momentum, is undoubtedly the reason Deputy Economy Minister Walther Otremba is predicting a contraction in Q2.

Exports continued to grow (+2.4%) but since imports rose even more strongly (+3.5%), foreign trade actually had a downward effect on gross domestic product in Q1 2008 when compared with the preceding quarter. So whatever else the Q1 headline number was about, for once this was not an exports story.

So we can draw two conclusions from all this rigmorole: firstly it would be far from in order to announce the Q1 2008 result as strong evidence for anything very important about the Germany economy or its future trajectory, and secondly, given that the inventory correction is virtually bound to take place (and that early construction momentum has almost certainly not been maintained - construction output was down 2.9% in April over March and by 2.3% over April 2007, and only bounced back 1% in May over April, so was still under the March level) we should not interpret a negative number in Q2 as meaning that Germany is actually entering recession at this point. Global trade is still growing (not as fast as previously, but still growing) and German exports are still sufficiently resilient at this point for this eventuality to be very likely.

For the German economy to enter recession the global economy will need to slow further - which all the signs are that it most probably will do, as country after country falls into the grip of higher inflation and increased central bank monetary tightening.

The important point to understand about the export sensitivity of the German economy is that this is a by-product of permanently weak household demand, which is, in my opinion, associated with the progressiving ageing and numerical stagnation of the German population.

Government Debt

Among the sources of support for the German economy in the coming quarters we should not count on the possibility of fiscal loosening. Germans debt to GDP ratio was 65% in 2007, down significantly from the 67.8% peak hit in 2005, and Germany has been gradually move the fiscal books back into balance (0% deficit in 2007) after four years of breaching the EU's 3% deficit limit (2002-2005). We should not expect any enthusiasm from the German government for hitting reverse gear at this point.

Indeed Finance Minister Peer Steinbrück is forecast this week to unveil a even tighter-than-expected 2009 budget in an attempt to stay on track with the target of completely eradicating the federal deficit by 2011. The draft budget will be put to the German cabinet on Wednesday and is thought to envision total federal spending in 2009 of €288.4bn, up 1.8 per cent from this year. The deficit is forecast to fall by €1.4bn to €10.5bn. The finance ministry’s four-year fiscal plan is said to be little changed from earlier versions and foresees a fall in the deficit to €6bn in 2010 and zero from 2011 onwards despite an average yearly increase in spending of 1.5 per cent.


There seems to be a general consenus at the present time that the German economy is slowing. Where there is no real consensus is over the rate at which it is slowing and where and when the slowdown will settle. It is already clear, however, that GDP growth in 2008 will be below the heady 2.9% annual rate achieved in 2006, or the 2.5% clocked up in 2007.

The median of five forecasts published in June by the major German economic institutes sees growth in the German economy this year of 2.2%. This really now seems a highly optimistic number, especially bearing in mind the economy may in fact have shrunk in the second quarter after expanding 1.5 percent in the first three months, according to the recent statement of Deputy Economy Minister Walther Otremba.

I personally will be very surprised if we see growth at or near the 2.2% the institutes are forecasting (and much less the 2.5% put forward in the now somewhat dated EU commission April forecast, although Eurostat now have a 1.8% forecast pencilled into their database). I even consider the 1.7% from the OECD and 1.9% from Morgan Stanley to be still on the high side given the extent of downside risk and the sort of real economy data we are now seeing.

At the start of the year the German government was reckoning on a growth rate of 1.7 per cent, while Peer Steinbrück is basing himself on 1.2% for the draft budget.

“Now the president of the Bundesbank told the cabinet it might be 2 per cent, to my surprise,” Peer Steinbrück informed the Financial Times in an interview this week. “For my 2009 budget, I estimated growth at around 1.2 per cent, which accounts for all the downside risk ... Some people say it might be 1.4 or 1.5.”

Obviously I am one of the people in question, since I would go much nearer to the 1.4% rate forecast by the IMF in its April World Economic Outlook forecast, and my reasoning would be as follows. We have already had 1.5% growth in the first quarter, but we may have a negative number to put next to it in Q2. Lets make a guess: -0.2%. That brings us back to around 1.3% (its not as simple as this in practice, but bear with me for a second). So then, what if we get, say, a reasonably positive Q3: 0.4% expansion, say. But what then if we get a contraction in Q4? Then everything would depend on the rate of contraction.

Well, there's a lot of guessing going on here, and we will be a little clearer when we get the Q2 number, but the basic structure of the situation is, I think, the one I am suggesting here. Very weak (and possibly negative) growth in Q2 followed by a "bounce back" in Q3, and then a second negative quarter in Q4, a quarter which could well by that point be the first of two consecutive quarters of negative growth, that is the first part of a recession.

In addition all the indications suggest that German consumption will continue to be weak throughout 2008. So if consumer consumption is at best flat, government consumption equally so, and investment and construction weakening, we are simply lefy with export growth, and here the outlook is definitely more negative in 2008 than it was in 2007. So I would say that, based on current data, 1.4% growth in Germany in 2008 looks to be a reasonable estimate at this point, and if there is risk to this call, then I would say that it was mainly downside.

Tuesday, July 1, 2008

Portugal Sustains

"Art has a function of teaching about the human condition. We live in hope, hope is fundamental" - Manoel de Oliveira

Manoel de Oliveira (photo and quote above) is a living example for the Potuguese people of how to force their way out of the low growth/low per capita income trap into which they have steadily stuck their neck. Oliveira celebrated his 70th last December - and how did he celebrate it: by starting work on a new film. Traditional productivity theory suggests most people slow down with age, but Oliveira seems to have done just the opposite - and since 1990, he has made at least one film a year. His secret for longevity, work much and rest little (oh yes, and also remember that living in hope is fundamental, it's funny, but my father who lived to be 84 and worked to 80 gave me the same sort of message). Indeed far from implementing a 35 hour week he seems to only stop on Saturdays - "This is the only day of the week that I rest," he told journalists back in December when he interrupted shooting on his latest film to give them a rare press conference. So in a country where the average age of leaving the labour force is currently 63, and where raising employment participation rates is a national priority, what better example of a "local hero" than Manoel. What follows will be an attempt to reveal just what it was he was so meticulously trying to capture with his camera in the photo above. Just call me an inveterate "peeping tom", lookout Portugal all is now going to be revealed!

But Some Reasons Why We Are A Little Short On Hope Right Now

Portugal, it seems lives in perpetual hope, hope for that sustained and substantial recovery which always, somehow and disappointingly, lies waiting for it just around that next corner but never actually appears. Equally Portugal is not in recession, at least not yet it isn't, although if we look at the most recent movements in the EU economic sentiment indicator, the Portuguese economy could hardly be said to be passing through one of its best moments. The thing is, since the turn of the century it has been hard for anyone to identify one of those "better moments" in the Portuguese case, or to offer some empirical justification for that evident existential need we all have to eternally live in hope.

Having said this, Portugal could also hardly be said to be riding the wave of a boom-bust trajectory (like its Iberian counterpart and neighbour), since if you never got the boom in the first place, well you obviously aren't going to get the bust part either. So it should not surprise us to find that after contracting slightly during the first quarter of 2008, the Portuguese economy has continued to move forward, and was even continuing to "sustain" a 0.7% year on year growth in Q3 2008. Hardly spectacular, but then (as we shall see) Portuguese growth has hardly been spectacular in recent years, but equally far from being a "worst case scenario".

But then, as we know, everything that lives was born to die, and so it will be even with Portugal's current (lacklustre) expansion, with the Portuguese economy seemingly set to contract this year for the first time since 2003 as its main export markets weaken and Portuguese consumers rein in their spending. Portugal's central bank now expect the economy to shrink by 0.8 percent in 2009 - a downward revision from its July forecast for a 1.3 percent expansion. Also according to the bank, the country’s economy probably grew 0.3 percent last year, a prognosis which seems reasonably realistic following Prime Minister Jose Socrates recent admission that the economy shrank 0.1 percent in the third quarter. So even while Portugal sustains, resistance, this year at least, would seem to be futile.

The Short Terms Dials All Move Over To Red

All the main short term indicators (industrial output, retail sales, employment etc) showed significant weakening in the second half of 2008 (industrial output, in particular, really went west in the second half - and together with manufacturing industry, construction activity was down, although it is important to note that in Portugal's case construction was never really "up" - or at least in recent years it wasn't as we will see below). Industrial output was down 2.9% in October over October 2007, and contracted on a year on year basis in each of the five previous months (see chart below). Retail sales were down 1.6 % year on year in November and by 1.4% from October (seasonally adjusted).

As just one indicator of the way demand for some Portuguese products is waning at this point, the three European countries most affected by the heavy-truck sales plunge are Spain, Portugal and Germany, with respective declines of 58 percent, 40 percent and 34 percent registered in November. As in other countries the automotive sector is being particularly hard hit, and the government announced a 200 million euro credit line for auto and car parts exporters back in December. The package, agreed between the government and companies including Volkswagen and Peugeot Citroen includes 70 million euros for training courses for some 10,000 employees - the Portuguese association of auto industry producers has estimated that the downturn in car sales will lead to 12,000 job losses during the first half of 2009. Economy Minister Manuel Pinho has stated that, including trade credit insurance of 300 million euros and the potential investments that the incentives should generate, the total value of the government plan is likely to be in the region of 900 million euros - not a lot of money in terms of the sort of programmes being seen in countries like the United States, but for a small, comparatively poor country like Portugal, with a government debt problem to think about, hardly insignificant.

Ever Weakening Trend Growth?

As the big wheel of global events follows its charted course, Portugal can at least be thankful for small mercies, since the country is not suffering under the added burden of a housing crash (it is not an Ireland, or a Spain, or the UK, or even, dare I say it, Denmark), for the very simple and straightforward reason that it never had a housing boom in the first place (or better but, since the late 1990s it hasn't had one, and one of the purposes of this article will be to examine just why that is). Portugal's problems are, unfortunately, more long term and more endemic, strikingly similar in many ways to those of Italy. So we should beware of making a simplistic generalisation and talking about a North-South divide in the eurozone. The economic profile of Portugal (or Italy) is really rather different from that of Spain (or Greece), in much the same way that France's economy is essentially very different from Germany's (of course, Sir Roy Harrod will probably be turning over in his grave at this point, with the thought of what this might imply for the theory of "convergence", but for now we might perhaps leave him in his tomb to timelessly struggle with this rather thankless labour and move on, since before jumping to too many overhasty generalisations it may be worth first examining in detail the actual dynamics of a number of the individual eurozone economies).

The nice thing about empirically grounded sciences is the freedom they give their practitions to follow (or chase after) the "facts", without the pressure of being compelled a-priori to reach premature conclusions, regardless of whether or not it is considered to be politically - or incorrect - so to do (hence Ben Bernanke's multiple references in "The Euro At Five" to the eurozone as a great experiment, a "natural experiment in monetary economics"). We economists have to learn to live with the experimental nature of our science, even if the "rats in the maze" may get somewhat frustrated with our efforts at times.

Now if we look at the chart below we can see that if quarterly growth in Portugal is sluggish, this sluggishness has in fact been operative over quite a long period of time.

In fact since Q1 2000 Portugal has had 2 recessions (when defined as two successive quarters of negative growth): in Q3/Q4 2002, and Q3/Q4 2004. There have also been 7 more quarters where growth has been negative: Q2 2000, Q1 2001, Q2 2003, Q3 2005, Q3 2007, Q1 and Q3 2008. That is out of a total of 30 quarters, the Portuguese economy has contracted in 11, or around 30% and the average GDP growth rate has been 0.37% per quarter or 1.48% per annum. For a country whose per capita income is the lowest in the EU15, and which is badly in need of "catch up" growth this is hardly a happy situation, and beyond the national administration should be giving food for thought for those resposible for economic policy across the Eurozone, and also among those among the EU10 who have recently joined, or are set to join, the common currency area.

Even more worryingly, Portuguese growth seems to have gone through three phases since the early 1980s, with each "wave" being weaker, and indeed during the years since entering the eurozone Portugal seems to have gotten absolutely no "boost" whatsoever.

No Housing Crash Or Pile Of Toxic Debt In Portugal

So what could explain this evidently "sub-par" performance? Well, during the years of ERM participation (the precursor of the euro) Portugal's nominal interest rates dropped from 16% in 1992 to the 4% eurozone entry rate at the start of 2001 - while real interest rates dropped from 6% to zero - so the problem doesn't appear to be - prima facie - what you could call an overly tight monetary regime: post euro-creation ECB interest rate policy has been largely accommodative to Portugal, and in particular interest rates were, by and large, negative during the entire period between the end of 2001 and the end of 2006. Yet, economic activity remained sluggish throughout this period, and even the construction sector showed little sign of life.

In fact the last house price spike Portugal had was in the years 1998/99, and during most of the years since Portugal joined the euro (as can be seen in the chart below) house prices have in fact been falling.

(Please click on image for better viewing)

And if we look at the construction output charts, during all of 2006 and throughout the first half of 2007 the Portuguese construction industry seems to have been in something of a deep slump.

Even more preoccupyingly, Portugal's construction industry seems to have past its historic peak in 2000, with the output index declining steadily ever since.

While the banking system may not be the most splendid of health (remember there is that little issue of the current account deficit to finance), it has not taken any kind of "full frontal" hit from the global financial turmoil - having little exposure to US sub-prime type debt, and no large pile of housing loan defaults set - Spansih style - to arrive and spoil the party. So Portuguese Prime Minister Jose Socrates may well have been right when he reiterated recently his government's view that no major Portuguese banks are likely to fail.

However, since the global financial crisis hit major U.S. and European banks last October, the Portuguese government has reacted by offering state guarantees of up to 20 billion euros on bank loans and 4 billion euros in capital for local banks. Portugal's top banks - Millennium BCP, Banco Espirito Santo and Banco BPI - all seem to weathered the crisis relatively well so far. The government has had to nationalize the small private bank Banco Portugues de Negocios (BCN) while a consortium of larger banks have been invovled in rescuing Banco Privado Portugues (BPP), but the financial problems here preceded the current global financial crisis and seem to have been merely exacerbated by the credit crunch.

The 2009 prospects for Portugal's construction sector seem pretty bleak for 2009 - after the sector probably failed to expand in 2008, following six previous years of decline. Manuel Reis Campos, president of the Portuguese Federation of Construction Industry and Public Works (FEPICOP), expects turnover to be around 20 billion euros in 2008, a similar number to 2007.

"At the start of the year we were saying the sector was going to grow 2.5
percent and what happened is that we have lost another year," Reis Campos told
Reuters. "The overall sector progress is going to stagnate in 2008," he said.
"The situation is so bad and the employment issue so serious that any (2009)
forecasts have to be very cautious."

Campos said the industry has been in decline since 2002 "and it's not a result of the current international situation". He expects the situation to improve in 2009 on the back of government infrastructural project (see below) but his outlook for residential construction is for yet another decline - possibly by between 3 percent and 5 percent. Residential construction has the heaviest weighting in the construction sector (38 percent) and the industry accounts for 5.6 percent of gross domestic product employing 11 percent of the workforce (560,000 jobs).

Real Effective Exchange Rate

One explanation which is often offered when people come to look at Portugal concerns what has been happening to what is called the Real Effective Exchange Rate. Now the Real Effective Exchange Rate (or REER) of a country is an instrument which can be used to assess price or cost competitiveness relative to the position of the country's principal competitors. The REER is an instrument which is widely favoured by economists since competitiveness depend not only on exchange rate movements but also on cost and price trends. Eurostat offers us one such measure of REER, and the REER used in the construction of the Eurostat Indicator has been deflated by nominal unit labour costs (for each economy as a whole) against a panel of 36 countries (EU27 + Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). A rise in the index means a loss of competitiveness (taking into account productivity changes via the movement in comparative unit costs), and as we can see in the chart below, Portugal has substantially lost competitiveness against Germany since 1995. Were a convergence in living standards taking place between Portugal and Germany via a more effective use of a pre-existing labour force, or a boost in productivity achieved through a shift across productive sectors (eg away from agriculture and into knowledge economy products) the we would not expect to see this pattern, since any increase in living standards would be accompanied by a maintenance in the competitive position. (This point, in Portugal's case, is unfortunately highly theoretical, since as we will see below, convergence in living standards is not in fact taking place. That is, Portugal really is stuck).

In fact I have been a little naughty here, since I have also included Spain in the comparison. I have done this since the argument that Portugal has lost competitiveness against Germany is fine as far as it goes, but as an explanation for why Portugal's growth has stagnated post 2000 it is clearly insufficient, since growth in Spain - at least up to 2007 - has been rather stellar, so the question should really not be why is Portugal so different from Germany, but why is Portugal so different from Spain (as I said above, we shouldn't be dividing Europe simply along a north south axis, and that the differences within regions (like also the Germany-Spain one) are also interesting and very, very revealing.

Now basically it seems to me that you can say either one of two things, but not both of them at the same time. Either Portugal should have had the same growth as Spain (all other things being equal), or Spain should have had as little growth as Portugal did. In reality the likelihood is that both countries have had their growth paths rather skewed (in opposite directions) by participation in monetary union, but going further along this path at this point would take us well beyond the matter in hand.

So what we have here is a very strange state of affairs indeed, and it should lead us to ask ourselves just what it is than has been going on in Portugal over all this time? In addition, and as can be seen below, Portugal's relative GDP per capita (vis a vis the EU27) has declined steadily since euro membership, after reaching a high point in 1999.

So What Is The Root Of The Problem?

Just what has been going on all this time in Portugal then? Perhaps the most systematic piece of work to date is a paper written by MIT Professor and Current IMF Research Director Olivier Blanchard - Adjustment within the euro. The difficult case of Portugal. Blanchard's argument, which is certainly the most coherent "mainstream narrative" we have at this point - and I hope I am not simplifying his argument excessively - would seem to run as follows:

In the first place Blanchard divides Portuguese growth into two periods. During the first of these - running roughly from 1995 to 2001 - Portugal experienced reasonably healthy GDP growth, a steady decrease in unemployment, all acompanied by a rapidly growing current account deficit. During the second period, roughly since 2001, there has been continuously weak economic growth, a steady increase in unemployment, while the current account deficit has remained stubbornly high, and even (since his paper was written) increased.

Blanchard argues that the proximate cause of Portugal's mid 1990s boom was participation in the ERM and in the build up to the euro (the longer term cause would, I feel, be some yet to be identified underlying structural transformation that was going on, trying to get to grips with this is the point of this article). This participation combined with expectations that participation in the euro would lead to faster convergence and thus faster growth for Portugal, lead to an increase in both consumption and investment. But, of course, as we have seen, this convergence did not take place, nor does it appear likely to do so.

During this phase Portugal's budget deficit decreased slightly, although discretionary fiscal policy was generally expansionary. Blanchard makes the point that between 1995 and 2001 the cyclically adjusted primary deficit (adjusted for the effects of lower interest rates and output growth) increased by roughly 4%. This choice of dates does seem to me however to be rather tendentious, since - as we can see from the chart below - the main increases in the deficit came after 1999, and in that sense are not really part of the period that should most concern us, which is the one immediately prior to the domestic consumption and construction fixed investment blow out. One possibility here would have be that the budget deficit simply "crowded out" private activity, and placed an excessive burden on an already overstrained capacity. But if we come to look closely at the timing of things, this argument may be harder to sustain than seems at first sight (and indeed government spending as a percentage of GDP only really started to rise sharply after 1999 - see chart further down the post - and thus post dates the contraction in private consumption).

The fiscal deficit was in fact reducing from 1994 to 1999, and only started to rise again after 1999. On the other hand, if we look at private consumption growth, we find a rather different pattern, since private consumption growth peaked in Q1 1999, and then dropped back steadily all the way through to Q2 2001, at just the time the fiscal deficit was increasing.

So the increase in government spending can be thought of as a knock-on consequence of the decline in private consumption growth and not the other way round. It was simply due to the automatic stabilisers coming into action. So the big question is why, in the Portuguese case, the construction and consumption boom came to an end when it did, while it continued and even accelerated in Spain and Greece, rather than why the fiscal deficit started to increase.

The drop in unemployment which accompanied the initial boom lead to significant labour market tightening, and this tightening - coupled with rising EU convergence expectations and talk of Harrod-Balassa effects and suchlike - produced a situation where wages increased rapidly in comparison with other EU countries. Again we should note the similarity between what happened in Portugal and what has been happening over the last two or three years in Eastern Europe, where certainly the comination of sharp decreases in unemployment and strong euro area membership expectations has acted like putting a lighted match to a tinderbox.

To take just one example, when Portugal joined the EU in 1986 workers without college education earned only 50% of corresponding French wages in PPP terms, while college graduates earned 72%. By 1994 unskilled and skilled wages had risen to 67% and 93% of French wages respectively. In addition, nominal wage growth was significantly higher than labour productivity growth, leading unit labor costs to rise at a substantially faster rate than the euro area average. Hence Portugal's competitiveness deteriorated, as did its goods trade deficit.

Blanchard takes the view that unemployment at the start of the first period was above what he terms "the natural rate" - since, he argues, while an unemployment rate of 7.3% (1996) is not especially high by EU standards, it was high in terms of what Portugal had become accustomed to by the early 1990s. Thus he considers that capacity existed for some growth in excess of "normal" was not problematic. By the end of the 1990s - so the argument goes - unemployment had become lower than the "natural rate" and non-inflationary "catch-up" growth started to become problematic - again it would be interesting to make a comparison with what just happened in Eastern Europe in this context.

Blanchard also takes the view (and I thoroughly concur) that some degree of current account deficit was clearly justifed in Portugal in the mid 1990s (since if everyone runs a suplus the whole global system cannot work), given that the arrival of both a lower real interest rate together and expectations for faster "catch-up" growth is likely to stimulate higher private spending, be this from private consumption or be it from investment. The real real issue is that this boom, in theory at least, should lead to a structural transition to higher productivity and higher value added activities, and the issue in Portugal's case is that the needed and anticipated higher labor productivity growth simply did not materialize. Instead, productivity growth nearly vanished, averaging 0.2% per year from 2001 to 2005.

The end result was that the investment boom came to an end as household spending effectively stalled due to the high levels of household debt which were accumulating and the deterioration in future prospects which was taking place (can anyone else smell the Baltics here??). So private consumtion growth stalled and household saving increased.

The end consequence has been that, in an environment where increasing exports to drive GDP growth became very difficult due to the absence of an independent currency and monetary policy and a lack of price competitiveness, the slower rate of consumption growth and the consequent weak investment demand have led to an enduring output slump, while Portugal's unemployment rate has now returned to its former higher level (7.9%) and the current account deficit has steadily increased, reaching 9.4% of GDP in 2007.

Spain, Portugal and...... Hungary

Several commentators have drawn attention to the similarities which may be discovered by scrutinising Portugal in the context of recent events in the East of Europe (see this example from Christoph Rosenberg), and I would like to take this opportunity to draw attention to the remarkable common points I have been finding between what happened in Portugal in the 1990s and what has been happening in Hungary since 2005 (or see this earlier post). In the first place because both countries found themselves faced with a twin deficits crisis, both saw fiscal spending surge sharply upwards as a response to a sudden drop in domestic consumption, both have been unable to sufficiently ramp up exports as a result of excessive downward rigidity is the wage setting process, both have had absolutely stagnant employment growth, and both, and here is the really unusual detail, were experiencing downward movements in their population at the time their problem really got going. Quite what connection one thing has with the other reamins to be established, but I beg to suggest that this correlation is far from incidental.

If we look at the Portuguese case we can see the downtick in overall population numbers quite clearly when we look at the relevant chart (see below), the unusual thing about the Portuguese case this is more the by product of "freedom of EU movement" outmigration (more appropriate to the Baltic and South East Europe connection than the Hungary one) than it was to the impact of lowest-low fertility, since while Portugal's fertility has been below replacement level since 1982, it only really fell below the critical 1.5Tfr rate in 1994.

If we look at the long term migration chart, we can see where the root of the problem was.

And if we also look at the chart below and see how the supply of remittances has dried up (ie all these potential young consumers have now become a net loss to the economy) we can perhaps begin to understand how it was that domestic consumption started to stagnate.

In theoretical terms economists have long spoken about the possibility of having multiple "equilibria", and how economic processes are to a certain degree "path dependent", well in the cases of Spain and Portugal we couldn't have a clearer example I think. If we look at net migration between 2000 and 2008, the difference between the two countries is plain to see. Spain went up and up.

While Portugal went down and down (see below). We couldn't have a clearer example of the contrast between positive and negative feedback processes, illustration of how most contemporary migrant flows are "labour market driven".

And again, if we think about house prices (see earlier Portugal chart) Spain was going through an enormous asset price inflation boom during these very same years.

So Spain and Portugal were receiving one and the same monetary policy, with very different results in each case, since while Spain's inflation accelerated during the highpoint of monetary easing, Portugal's rate even dropped. This should give some food for thought to all those who simplistically talk about the "pernicious" effects of low interest rates.

And again, as can be seen in the next chart, one and the same monetary stimulus lead to very different domestic consumption paths.

Indeed while Spain's unemployment fell during the first years of euro membership, Portugal's unemployment actually went up.

And yet if anything average annual wage cost growth in Portugal has been lower.

In Conclusion - Going Off The Rails In Portugal

This is where Portugal is today. In the absence of policy changes, the most likely scenario is one of competitive disinflation, a period of sustained high unemployment until competitiveness has been reestablished, the current account deficit and unemployment are reduced............ It is a process fraught with dangers, both economic and political, and one which can easily derail.
Olivier Blanchard - Adjustment within the euro. The di±cult case of Portugal, November 2006.

Well what we most certainly have not seen in the Portuguese case in any sort of credible process of competitive disinflation (which makes me wonder about the extent to which any such process could work in an East European context like Latvia or Hungary, if the prospect of Eurozone membership is dangled out just before them - falling wages never prove popular anywhere, and politicians have a strange habit of not carrying through things which turn out to be unpopular). So has Portugals economic and political development process been thrown off the rails. I fear it has.

Possibly the clearest example of the extent to which Portugal's economy has been "derailed" is to be found in the stagnation of the labour market. After shooting up as the turn of the century (possibly in a process which involved deep "whitening" of the submerged economy, see chart) the number of people employed in Portugal has actually marked time, and now during the present global recession it may even drop back again, to what would effectively be pre 2000 levels.

And now with a global economic crisis breathing down our necks the situation is likely to get worse not better. Indeed Portugal has just announced a 2.2 billion euro package to boost its flagging economy. No harm in that, but when will we really bring the fiscal deficit adjustment to a satisfactory conclusion? The package will focus on investment in schools, boosting technology and alternative energy. The finance minister has said the package is expected to give a 0.7 percentage point boost to GDP in 2009.

In 2008, the general government deficit was forecast at 2.25% of GDP, down from 2.6% of GDP in 2007, but this number now seems to be out of date hardly before the ink was dry.

In fact the government deficit is now projected to rebound to over 3% of GDP in 2009, this is hardly alarming given the global backdrop, but it is also far from being a positive development. On the revenue front, the economic downturn is expected to take a significant toll on tax proceeds, while on the spending side, some acceleration is expected on the back of higher social transfers, which reflect, first, the (partial) indexation of cash transfers to the previous year's inflation rate; second, recent policy measures, and, third, no further decline in unemployment benefits.

Among new spending plans there is a 43 billion euro public-private infrastructure development plan (which is set to run through to 2017), and which includes projects to build a new international airport near Lisbon and a bridge over the Tagus river. The government has also approved an economic stimulus package worth nearly 2.2 billion euros.

For 2010, applying a simple no-policy change assumption, the EU commission currently forecast the government deficit to be around 3.25% of GDP, thus after falling in 2007, the government debt to GDP ratio is projected to resume its upward trend and reach 66.5% of GDP by 2010. And this on a "best case" (no policy change assumption) scenario, when clearly there is abundant downside risk to any present forecast.

Of course another of the problems Portugal will have in 2009 is that of financing and reducing its current account deficit, which is estimated by the IMF to have hit 12% of GDP in 2008. In particualr I would draw attention to the structural damage to the income account (see chart below) which has been caused by the external financing required by so many years of running such large deficits. Thus as we get into 2010/11 the risk of a serious financing problem on the back of a pair of "twin deficits" which simply get worse and worse is hardly to be taken lightly.

Is There A Deflation Risk?

Portugal is currently undergoing something of a strong disinflation process, with the annual CPI falling from a high of 3.4% in June to 1.4% in November. Not only that, the general HICP index has actually declined on a month on month basis for four of the last five months.

And the danger is that demand falls Portugal could be dragged off behind it into deflation territory. And the coming contraction could be a sharp one with both Bank of America and Deutsche Bank predicting that the economy of the 16 nations that share the euro will shrink by 2.5 percent this year.

European Central Bank council member and Bank of Portugal Governor Vitor Constancio is aware of the danger and has indicated that the ECB is prepared to reduce borrowing costs further to prevent inflation slowing “significantly” below its 2 percent ceiling, even going so far, if necessary, as to introduce some variant of quantitative easing. He still thinks it won't happen, but he is well aware of the possibility, as indeed we all should be.

“Any risks of inflation settling well below that level must be preventively contained with interest-rate reductions.........In the middle of the year, we may have some months of negative inflation,” though “not deflation,” Constancio said “the priority” for European governments is “to limit a recession that became inevitable but that has to be contained in order to avoid scenarios of depression and deflation.” If deflation “gains momentum, it’s very dangerous,” Constancio said. “It’s very difficult to escape from a process of deflation.”