The Global Spectator by juan hervaada

THE GLOBAL SPECTATOR SPAIN

POLITICIANS, BANKS, STATISTICS LIES & SOVEREIGN DEBT

• Spain At The Crossroads This is an important, possibly decisive moment in the country’s history. • Rough Ride for the Spanish Financial Sector

• Spain’s Unemployment Statistics Brother, Can You Spare a Leak? • What a difference a day made! • The thermo-nuclear option Can politics win against the capital markets?

Coffee Break with NOURIEL ROUBINI

This Crisis Is Morphing GLOBAL EXCHANGE

EUROZONE

EAST OF THE DANUBE

ASIAN BAROMETER

• Rising Like A Ton Of Brics The 2008 Redux That Could Pack A Vicious Sting In The Tail

• Angela Merkel: A Lame Duck Running Wild

• The Comeback of a Political Survivor Conservative Landslide in Hungary

• The Long Sleep of Japan

• Don’t Raise Taxes, Spend Less! • Angela Calling (the Shots?)

• Building Hedges Around Greece? • Hell Knows No Fury Like A Financial Market Being Told You Are About • Estonia’s Big Euro Gamble To Become The Next Greece

• China, The Megatrillion Question • More On China’s Real Estate Bubble The Magic Goose

THE GLOBAL SPECTATOR Is published by

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EURO LOGE

Hanging In The Balance:

The Eurozone And Its Future The future of the Eurozone is decidedly hanging in the balance at the moment, and with it the future of the entire global financial system. And it isn’t about economics anymore: it is all about who does what, and when, and how everyone else reacts. It is hard not to have the impression that the ten-year euro experiment is gradually coming to an end, although the when and the how is still impossible to discern. One thing is sure, whatever the outcome, Europe’s economic and political structure will look very different once the immediate crisis is finally over. The heart of the problem is that bedrock of the currency union, the political leadership in Germany, is basically trapped and ineffective – gridlocked between the hard rock of Southern European intransigence, and the bad place of German voter tolerance. There is a hard circle to square here. It would be nice to be able to say that the South was suffering from reform fatigue, but it isn’t, since by and large there hasn’t been any. This is the big failure of the Euro, which was introduced as a structure to apply fiscal pressure on the weaker economies but has only served to The heart of the problem is that bedrock of the currency union, the lock them into ever deeper political leadership in Germany, is basically trapped and ineffective debt.

– gridlocked between the hard rock of Southern European intransi-

On the other hand Gergence, and the bad place of German voter tolerance. There is a hard many is suffering fatigue, circle to square here. handout fatigue, especially with the problems of Southern Europe coming so closely behind their earlier experience with the integration of Eastern Germany, which is now normally accepted to have been a failure. So German tolerance will now be low, and this is just where the problem comes (see Angela calling, in this issue). At the same time, those who live in the South are, by-and-large, simply not keyed-up and motivated for change. Basically they simply don’t see what the problem is, or what all the fuss is about. Weren’t things working just splendidly over the last decade – money was cheap, and debt was easy, and they bought lots of brand spanking new products from Germany and Holland, keeping the factories rolling from Frankfurt to Amsterdam . Of course, the US sub-prime crisis did present something of a problem, but isn’t all this resolved now, and won’t things soon be getting back to normal again? This, at least, is what the political leaders are almost uniformly telling them. And as for the competitiveness problem….. what competitiveness problem? Oh yes, of course the Germans have unnaturally held their wages down, and have become too competitive, but they will have to change that, in the interests of “global rebalancing”. So there is a communication problem. There is no effective communication between the different societies and cultures that go to make up the zone. Of course, nothing here is determined in advance, and economic processes are path-dependent ones, so at this point all that can be recommended is extreme vigilance, and taking events one day at a time, as they happen, since naturally, in a path-dependent sequence, what happens one day will surely determine the range of alternatives open to choose from on the next.

EURO LOGE The sorry result of all this indifference has been that while Europe’s leaders continue to dither, the common currency has continued its downward path, with investors fretting endlessly about the absence of precise detail on the bailout proposals, and the lack of any clear commitment on the part of the Greek government to a package of new, and more effective, measures. At this point it still isn’t clear whether behind all the EU imprecision there lies a strategy to force the Greek government to accept stronger conditions from the IMF (the optimistic view), or whether it is simply an attempt to paper over deeper concerns about the long term future of the whole monetary union project . This communicational deficit has now become a real handicap as all it does is pile ever more confusion on confusion. Most of the commentary is still framed in terms of fiscal corrections, and honouring them, yet as Nobel Economist Paul Krugman continually points out, the problems being experience on Europe’s periphery are not simply fiscal ones, they are about structural imbalances and the lack of competitiveness, and raise questions which go to the heart of the functioning of the common currency. More evidence for the fact that the Eurozone’s future is hanging in the balance can be found in the way economists, analysts and financial markets alike all seem to be taking the view that the current wave of Brussels inspired policy initiatives constitute little more than a continuing process of too little, too late. Countries like Greece and Spain have little alternative to carrying out a substantial process of deflation (internal devaluation), and doubts about the effectiveness of the effectiveness of such action are only further fuelled by the persistent attempts of the parties involved to deny that such a measure is either necessary or desireable. Evidently these outcomes were not anticipated when the monetary union was set up, but that is no reason to now remain in Countries like Greece and Spain have little alternative to carrying out denial now. Far better a substantial process of deflation (internal devaluation), and doubts to recognise mistakes, about the effectiveness of the effectiveness of such action are only learn from them, and move on. further fuelled by the persistent attempts of the parties involved to

deny that such a measure is either necessary or desireable.

As custodian of the shared currency, the European Central Bank has operated more by stealth than by dictat throughout the present crisis, quietly opening lifelines to all the most seriously affected countries by effectively buying their government bonds through specially created credit windows. This softly-softly approach worked for a time, keeping much of Europe’s periphery in a state of fragile equilibrium, where countries who found their economies folding in on themselves had no real incentive to takle their problems by the roots, but were able to survive from one day to the next via an intravenous feed of ECB credit. They were able to do so until a few weeks ago, that is, when it finally became apparent that ECB President Jean-Claude Trichet, and his German anchormen over at the Bundesbank had gotten tired of simply funding procrastination, and needed to see some signs of real progress. And now, no matter how many times Monsieur Trichet calls the idea of Eurozone break-up absurd, market participants remain unconvinced. It had been hoped that monetary management for the currency union could be carried out via a hybrid institutional structure (the ECB plus national fiscal policy, with “light” monitoring from the centre via the Stability and Growth Pact), and that no bailouts or closer political integration would be needed. Again, it is now evident that this methodology simply doesn’t work, but there is no easy road back. The biggest challenge now facing the EU is thus one of its own making – Europe’s leaders need to be bold and resolute enough to convince markets that they understand and will do what is needed. That is to say that

EURO LOGE they will implement the evident institutional changes necessary to put the process of monetary union on a firmer and more sustainable institutional footing. Either that, or get ready for an orderly-disorderly disintegration. As we said at the start, now, more than ever the future of the Eurozone is hanging in the balance.

Letter from the Editor Hello everyone, and welcome to the European Edition of of Global Spectator, which is also its first English edition. These are interesting times indeed. Three years after its initiation, the global crisis which broke out in August 2007 still shows no sign of abating. Certainly most developed economies have now stabilised, and many emerging economies are now expanding rapidly, policymakers have now started to wake up to a harsh reality - the advanced economies have been stabilised by taking recourse in large government fiscal deficits and massive injections of liquidity from the central banks, and no one really quite knows how the patients will respond as these “temporary emergency measures” are withdrawn. Unquestionably, with fiscal retrenchment now on the cards all over the globe, growth in 2010 looks like it is going to be very hard to come by. Not that such fiscal stimuli would be unjustified - if we could be sure that they would give the much needed time for our economies to recover of their own accord. But it is exactly just this kind of automatic recovery which looks like it may not be about to happen of its own accord, and it is in this sense that indebting future (smaller) generations to pay for policies which aren’t work becomes a questionable practice. In particular the problem of finding solution is made doubly complicated by having some of the key economies inside a currency union where making corrections is no easy task. In addition having a bi-polar monetary system where problems in Greece make export lead recovery in the United States much harder to come by due to the strengthening in the dollar only adds to the problems we face which are crying out for solutions. Unfortunately, we at Global Spectator don’t have all those solutions just lined up and ready to go. What we can do is identify and talk about the problems, which arguably constitutes one significant step forward. As someone once said, things that don’t work keep on running for as long as they can, and no longer. We’d better make sure that before that day finally comes our collective “plan B” is well and truly up and running. Thank you for reading, and we hope you enjoy the experience. Yours, Edward Hugh, European Editor of The Global Spectator

EUROPEAN EDITION

In this issue Editorial • Hanging In The Balance: The Eurozone And Its Future • Letter from the Editor

COFFEE BREAK • Nouriel Roubini This Crisis Is Morphing By Guiomar Parada 6 GLOBAL EXCHANGE • Rising Like A Ton Of Brics The 2008 Redux That Could Pack A Vicious Sting In The Tail The Global Spectator Global Strategy Team

• The thermo-nuclear option How politics can win the battle against the capital markets

SPECIAL WE TOLD YOU SO …

By Detlef Gürtler 52 • Spain At The Crossroads This is an important, possibly decisive moment in the country’s history. By Edward Hugh 54

• Don’t Raise Taxes, Spend Less! By Juan A. Hervada 21 • Angela Calling (the Shots?) By Edward Hugh 25 EUROZONE

EAST OF THE DANUBE • The Comeback of a Political Survivor Conservative Landslide in Hungary

• Building Hedges Around Greece? By Claus Vistensen 32 • Estonia’s Big Euro Gamble By Mikk Salu 35

By Mark Pittaway

SPAIN • Rough Ride for the Spanish Financial Sector By Francisco Cabrillo

• Chile Back to International Bond Markets By Beng Mortenson

• Drug cartels lose weight in Colombia By Beng Mortenson

• Argentina – Spring K By Rogelio Biazzi 73 • Chinese Money to Venezuelan Regime China gives 20 Bn dollars to Hugo Chavez By Francisco Miranda

ASIAN BAROMETER 38

• The Long Sleep of Japan By Claus Vistessen 76 • China, The Megatrillion Question

• Spain’s Unemployment Statistics Brother, Can You Spare a Leak? By Edward Hugh

By Mikel Abasolo 80

BARAJAS T4 • Pole Position By Rocío Albert 45 • What A Difference A Day Made! by Lucas Monteiros

• Spain’s Economy The Spectre Which Is Haunting Europe (Sep 09) Pg. 88 • Does anyone know who’s flying that plane? (Feb 10) Pg. 96

• Hell Knows No Fury Like A Financial Market Being Told You Are About To Become The Next Greece

LATIN AMERICAN WIRE

• Angela Merkel: A Lame Duck Running Wild By Detlef Gürtler 29

• A reflection and an announcement Pg. 87

• More On China’s Real Estate Bubble The Magic Goose By Kim Polder 83 • India: Tighten Your Seat-Belts For A Not-So-Bumpy Ride by Amrit Hall 85

GLOBAL EXCHANGE

Coffee Break With

Nouriel Roubini By Guiomar Parada (*)

This Crisis Is Morphing

Talking on the sidelines of the Economics Festival held recently in Trento, Italy, financial crisis “guru” Nouriel Roubini took time out to give The Global Spectator a glimpse of some of the mechanisms that lead to financial crisis, in the process going well beyond the theme of this year’s Festival – the need for economic literacy. Presenting his new book “Crisis Economics”, co-authored with Stephen Mihm and just out in Italy, Nouriel Roubini argued that financial crisis are “predictable white swan events, rather than unpredictable and random black swans”. The kinds of financial crises that have previously occurred rather rarely, Roubini says, now occur more frequently and with greater virulence than in the past; and their economic, fiscal, financial and social costs are rising. Thus, as a phenomenon they are becoming more of a rule than an exception,” in spite of the fact that the signposts of asset boom and bubble, followed by the inevitable bust and crash which follows are highly predictable if one looks at the economic and financial indicators that show the build-up of such excesses. Global Spectator’s Italian correspondant Guiomar Parada asked Nouriel Roubini for his opinions about the current crisis surrounding the Eurozone.

GLOBAL EXCHANGE Mr. Roubini, a lot of people are now starting to ask themselves just how growth is going to be generated in the euro area, in order to pay for the ever increasing debt, and about the sustainability of the austerity plans designed by some peripheral European countries. Would you consider it a misperception to say that the current economic policies being implemented to steer Europe out of the recession are â&#x20AC;&#x153;short runâ&#x20AC;? policies? Is there a logic behind them, or is it just a question of shortsightedness? I think you make a valid point when you say that European policies, as seen in the various interventions and policy actions, are short term and shortsighted. That is the case, for example, when governments spend too much running up large deficits before the crisis, which eventually have to be paid for when trouble actually occurs, as in cases like Greece and Hungary. Large short-term budget deficits lay the basis for long-term public debt. This is especially a problem when you do not have a properly supervised and regulated financial system, and when you allow asset and credit bubbles to build up along with the steady accumulation of debt and of unsustainable leverage. The excesses eventually burst into financial crises and then the whole system risks going bust. Short term you get the benefits of higher All this money does not come for free but with severe conditionalities growth and rising living standards on the back of the higher leverage, but then you get to pay for this with sub par growth and falling living standards over time. Furthermore, given the good times, many governments in the euro zone should have done much more in the way of structural reforms to increase productivity and growth, as propounded in the goals of the Lisbon Agenda. But such measures were not carried out even in the good times, because politically it is difficult for governments to do things that entail short-term sacrifices and costs, for positives that you will reap in the long run. So there is an element of shortsightedness at the policy level in many economies around the world. There is no talk anymore about exit strategiesâ&#x20AC;Ś There are too many mistakes being made. Europe, Japan, and other developed economies are just kicking the can further down the road, because you have the debt problems of the private sector, of households and of banks, and now this debt has been socialized and put on the balance sheets of governments. A number of governments now have unsustainable debt levels, and are faced with the possibility of bankruptcy, and now we are adding to the problem by providing funds from the euro zone countries, the ECB and the IMF. Eventually this is only going to add to private debt, to public debt, to public national debt or even to multilateral public debt. At some point or another, the system is going to crack, because of the high leverage attained and the difficulty of achieving growth as households, the public sector, corporates and the financial system all try to deleverage together. We are increasing the extent of debt and leverage in a way that is essentially pushing the problems into the future rather

GLOBAL EXCHANGE than of resolving them in the present. So we need to produce more, to save more, to see into the future. But in Europe this boils down to politics, to the ability to impose certain policies… Yes, but many of the political problems in Europe and how to resolve them, and how to find solutions to get out of the crisis, many of these public and financial problems of the euro zone are not just problems of the individual countries, but of the entire euro zone. They are collective problems. So you need a coordinated package of adequate policies where Germany, the ECB, the richer members of the euro zone do the right things collectively in order to avert a financial crisis. Let me make a point here: this crisis is not over yet, but it is morphing from a private debt crisis to public debt crisis and we are about to face the consequences of massive leveraging. As you saw, a huge potential bailout for Europe, involving 750 billion euros gave the markets a respite that lasted just a few days. The markets are wondering what policymakers really can do in these circumstances – of course, you need to tax more and spend less, but that fiscal austerity leads to recession and impacts on short-term on economic activity, which means in turn that stabilizing the debt becomes ‘mission impossible’.

Let me make a point here: this crisis is not over yet, but it is morphing from a private debt crisis to public debt crisis and we are about to face the consequences of massive leveraging.

Furthermore, there is an issue of competitiveness of much of Europe with the rest of the world. A number of EU countries have suffered a serious loss of competitiveness to other countries, because with inflation high over the last 10 years wages and unit labor costs simply kept rising. Then there the conditionalities that come with the bailout packages. On the other hand not stabilizing the debt will only bring an even longer and deeper recession. So what can you do? There are a number of options, but most of them are not very viable. Deflation is one, but this is no solution, because disinflation brings recession, and debt rises as a % of GDP, and politically this would not be bearable since it easily could lead everyone into a double dip recession. So what you can do is accelerate the proces of structural reform; dynamise corporate restructuring; and look for productivity growth, while maintaining a cap on wages in order to bring down your unit labor costs. But guess what: it took 10 to 15 years for Germany to achieve the current levels of productivity.

“… all this is going to add to private debt, to public debt, to public national debt or even to multilateral public debt. At that point the system is going to crack …” 10

GLOBAL EXCHANGE In the case of Greece or Spain, even if they would succeed in carrying out structural reforms now, the results would be reaped in 10 years from now – in the meantime you’d have loss of work places during the restructuring of the private sector and short term economic contraction. Deflation is thus not an option and structural reform needs to be undertaken, but it does not bear results in the short term. So, in order to forgo default and an eventual disorderly exit from the monetary union of some countries, a euro devaluation is necessary to restore competiveness. But in extreme cases, like that of Greece, if the country were not able to resolve its fiscal problems cutting spending and raising taxes, then the only option would be an orderly restructuring of public debt, since they don’t have the option of monetizing the debt and default would be socially unacceptable. Let me explain: even if Greece should succeed in carrying out the necessary adjustment, its problem is insolvency, so even if it could obtain a draconian 10% reduction in the deficit/GDP ratio, even after 10 years of recession its debt level would stabilize at something like 145% of GDP, so while Greece needs to carry out the necessary fiscal adjustment, at the end of the day it will still need to do some sort of restructuring of the public debt. The important point to grasp is that what is needed is a plan for an orderly restructuring as has been done in other insolvent countries like Pakistan or the Ukraine, exchanging old debt with new maturities, stretching out maturities… Yes, it is a haircut, but this is priced in by financial markets, and the longer maturities do not weigh on the banks at the accounting level, so they do not constitute an additional loan. Thus there are ways of an orderly restructuring of the public debt, and it is better to plan it in advance in order to avoid contagion and crises or wait for a default that eventually will occur. The ECB and the EU should not be continually kicking the can further down the road. The trade-off? The trade-off for all countries is that if you exit the fiscal stimulus you have recession and deflation, but if you maintain the fiscal stimulus for too long, or if you monetize it, you get inflation. It is a hard trade-off between the short and the medium term. So we need fiscal austerity, we need monetary easing, and Germany and the other stronger countries should increase real wages to boost consumption.

The social and political situation in Spain is unsustainable. Orderly restructuring is not impossible because there is an institutional mechanism available to proceed to an orderly restructuring of Spain’s public debt. 11

GLOBAL EXCHANGE Some say there is a need to rethink the economic model – the continental welfare states versus the Anglo-Saxon laissez faire... Even the Anglo-Saxon model failed because of a lack of regulation, that lead for example to distortions in compensation and excessive risk taking. But banks failed in continental Europe too and contraction of GDP in Euroland was higher than in the US. Even so, there was initially some complaisance in Italy, France and Germany, but now we see that also the European social welfare state model is broken. In order to have flexibility Europe needs to learn not to protect jobs, not sectors, but to protect workers, so there is a need to rethink the social welfare state. In the euro zone, for example the social and political situation in Spain is unsustainable. Spain has a lower government debt to GDP ratio, but it has other specific criticalities: 1 - unemployment at 20 % and at 40% among the young; 2 - a huge housing bubble that has done a massive collateral damage to the real economy; 3 - a huge fiscal cost of bailing out financial institutions; and 4 – even more than Italy, a lost of competitiveness. In the Spanish case an orderly restructuring is not impossible because there is an institutional mechanism available to proceed to an orderly restructuring of Spain’s the public debt. As to the global imbalances – where do see the main sources of risk down the road? Is there any particular element that we are missing? Well, I think that the markets are reflecting the main sources of the highest risks: one is the euro zone and the risk that the financial woes lead here to a double dip recession; the other is the slowdown of growth in the US and a recovery that is showing to be anemic; the third is Japan, with its deflationary problems and a very ineffective government; and finally China, were there is evidence that the overheating of growth is slowing down and this is dangerous. So weakness in the euro zone, in the US, in Japan and in China – there are several elements here of potential damage.

(*) Guiomar Parada, is the new correspondent for The Global Spectator, based in Italy. Fluent in six languages, and specialized in economics and finance, she had a long experience in television before going back to writing for the Italian quality press, among which Il Riformista, Limes online, the website of the Italian Review of Geopolitics, D Repubblica delle Donne. Her editing/translation work has been approved and praised by economists such as Nouriel Roubini, Luigi Guiso, Stephan Collignon, and Eric Jones. She grew up in Buenos Aires, and worked in Milan, Rome, New York (RAI Corporation) and Rio de Janeiro (TV Globo).

GLOBAL EXCHANGE

Rising Like A Ton Of Brics The 2008 Redux That Could Pack A Vicious Sting In The Tail From the Global Spectator Global Strategy Team

Who exactly is on their way up here?

If the situation in Europe seems confusing, the broader international stage presents us with a narrative that is well-nigh unfathomable. Who exactly is on their way up here, and who is in terminal decline? It is all so hard to read, especially after a generation when investment in the mature economies has been the next best thing to risk free, while emerging economies like those to be found in Latin American were normally considered to be the breeding ground for what was likely to become the next planetary â&#x20AC;&#x153;basket caseâ&#x20AC;?. The burgeoning Eurozone crisis (see editorial [9]) only serves to present in clearer relief than ever the absence of a viable alternative to the US dollar as a global reserve currency. The reponse to the crisis in all the major advanced economies has generated large quantities of liquidity, and this liquidity, far from stimulating a sustainable expansion in their generally overleveraged economies, has tended to leak out across the globe causing unpredictable and often perverse consequences elsewhere. After all, wasnâ&#x20AC;&#x2122;t it only yesterday that the vast majority of traders and analysts were busy preaching the perilous nature of the US twin deficit, and the virtues of the dollar sell-off, with investors and central bank reserve managers ditching the currency with a fervor which lead to fears that an imminent

GLOBAL EXCHANGE collapse in the currency was at hand. Then suddenly, it all came screeching to a halt, Greece shot up over the radar, and what was downside suddenly became upside. Now it is the Euro, and the possibility of it an early and imminent termination of what Ben Bernanke once called “that great experiment” that is in the forefront of everyone’s minds. Even more disturbingly, under what we could now call the “new global paradigm” fund managers are increasingly arguing that it is Latin America, and Asian powerhouses like India and Indonesia that represent the new planetary “safe havens” when compared with the heavy indebtedness of their ever more elderly Western counterparts, with their massive outsanding and undercovered pension liabilities. In order to wend our way agily through this new global habitat we need to constantly keep in mind that economic processes are complex ones, and that there is always more than one thing happening at any given moment in time, even if journalists and investors often find it easier to work within a more monotonic and one-dimesional narrative framework. The problem is that the “let’s keep things simple” approach just doesn’t work in a case like present one, and we should never forget that during the current crisis we have a complex interplay of both cyclical and structural elements continually at work. Structurally, it is clear that the architecture of Bretton Woods II has started to creak at the edges, and while, in the longer run, we are almost certainly looking at a historic decline in the central role played, for more than half a century now, by the dollar as the undisputed global reserve currency we should never forget that while, as Keynes so memorably put it, in the long run we are all undoubtedly and undisputedly dead, we ain’t dead yet, and news of the early demise of the dollar has surely been vastly overstated. Put another way, while Bretton Woods II has surely seen its best days, till we have some clear perspective on what can or will replace the old arrangement, it is hard to see a major structural adjustment downwards in the value of the dollar, and especially so now that the main rival, the Euro, is looking decidedly groggy as it flounders about on the ropes. As by now must surely be clear to everyone, and despite all the talk about the Euro becoming the new reserve currency, Europe’s economies are simply not strong enough, and their degree of institutional integration is not deep enough, for the currency to step in and fill the hole which would be left by a terminally ailing dollar. At the same time, the US economy is neither vibrant enough, or internationally competitive enough, for the USD simply to go back to where it used to be, assuming for itself the earlier exclusive reserve currency role. So apart from the evident short term structural factors, dollar upside is simply reinforced by the absence of credible alternatives, and by the fact that many of the other key players – like the Chinese or the Japanese – are extremely reluctant to see the currency slide too far due to both the the losses they would be forced to take on the dollar-denominated instruments they hold, and the problems this would create for their export sectors . The Russians, on the other hand, seem to

GLOBAL EXCHANGE constantly talk the USD down while at the same time borrowing in that very same currency – so read this as you will. In addition, given geopolitical considerations, it is hard to envisage a long term and durable alternative to the current version of the Bretton Woods set-up that doesn’t involve the Rupee and the Real, but these currencies are surely not ready for this kind of role at this point given the stage of development which characterises their economies. So for the time being, the best approach we seem capable of mustering is to simply stagger on.

The Liquidity Cycle The global liquidity cycle which started in 2003 (following the introduction of quantitative easing in Japan), and which accelerated in the second half of 2007 on the back of the generalised anti-crisis measures introduced in the developed

The New Global Paradigm, you said?

economies, came crashing to a close with the demise of Lehman Brothers in the autumn of 2008. The cycle has now visibly been renewed, even if this time it “certainly is different”, for the time being at least, as it is the USD that has stepped-in to occupy the slot formerly occupied by the Japanese Yen - as one side of the carry-trade pair of choice – since base money has been pumped up massively in a US economy where there is little demand from consumers for further indebtedness. The consequence of this is that the broader monetary aggregates haven’t risen in tandem, leaving large pools of liquidity which can simply leak out of the back door. Accurate estimates of the size of the yen carry trade that built up between 2004 and 2007 are hard to come by, but before peaking it is not unreasonable to think it may well have hit $1,000 billion. But even this extremely large number is put in the shade by the $1,500 billion figure that Zhu Min, deputy governor of the People’s Bank of China, recently attributed to the USD carry trade, which he described as “a massive issue.. (since it) …..is much bigger than Japan’s carry trade was.” So one of the perverse consequences of the Federal Reserve monetary easing policy may well be that rather than stimulating growth inside the United States itself, the liquidity generated may simply serve to finance strong consumption (and even local bubbles) elsewhere – in countries like Norway, or Australia, or emerging economies like South Africa, or Brazil, or India – as the IMF have stressed in their recent Global Financial Stability Report. For more than a year now the Federal Reserve has kept its short-term interest-rate target near zero and pledged to keep it there for an “extended period”. It has also bought $1.7 trillion of long-term bonds, primarily mortgage-backed securities (MBS), in order to try to hold down long-term interest rates. And although there has been some speculation the bank is near to signalling an exit from its ultra-easy monetary policy, by altering its “extended period” commitment as early as its next policy meeting, this seems extremely unlikely, especially with the strains being felt in the global financial system on the back of the

GLOBAL EXCHANGE Greek crisis. So the show seems set to continue, for some more months at least. But even were the present fragile equilibrium in the capital markets to unwind when the Federal Reserve start to seriously talk about withdrawing such “temporary” measures, the unwinding is unlikely to be extraordinarily violent, since the Japanese Yen can simply move back to where it was and step in to plug the gap, as the Bank of Japan will certainly not be in any position to raise interest rates anytime soon given the depth of the Japanese deflation problem. Indeed, the possibility would arise of investors once more being able to borrow in Yen to carry out a comparatively low-risk low-yield trade in USD denominated instruments, sending the Yen shooting downwards, to the benefit of Japanese exporters but to the detriment of the US current account, which is surely why the Yen/Dollar trading band is currently so finely balanced, with clear limits to movements in one direction or another, while the wild card is really the Euro, together with the fears of what might happen if the Germans get tired of supporting the Greeks. Thus, as a result of the new funding role which has been marked out for the dollar the yen has remained at what are preocuppyingly high levels for both Japanese exporters and government. And, even though the Yen has fallen slightly in recent days, it still stubbornly remains around the 93 to the dollar range, well below the 120 per dollar level that members of Japan’s ruling Democratic Party of Japan recently identified as being desireable and necessary for Japan to escape from the ongoing deflation spiral in which it finds itself trapped.

The new global paragigm is characterised by a continuing and substantial flow of funds out from the stagnant developed economies, and towards fast growth emerging market economies right across the globe. The real danger here is not of a reversal of such flows produced by a return to monetary orthodoxy at the Federal Reserve, but rather of an unfortunate financial event, perhaps on Europe’s periphery, which would send investors scuttling home for safety, as we saw in the aftermath of the Lehman Brothers collapse in 2008. Financial Event Vulnerability and the New Global Paradigm The new global paragigm is, as we have seen, characterised by a continuing and substantial flow of funds out from the stagnant developed economies, and towards fast growth emerging market economies right across the globe (with the notable exception of Eastern Europe). The real danger here is not of a reversal of such flows produced by a return to monetary orthodoxy at the Federal Reserve, but rather of an unfortunate financial event, perhaps on Europe’s periphery, which would send investors scuttling home for safety, just as we saw in the aftermath of the Lehman Brothers collapse in 2008. Certainly what we are seeing right now looks remarkably similar to what we observed in the first half of 2008, with real exchange rates appreciating rapidly right across the emerging market board. Brazil’s real has risen by 27 per cent, Russia’s rouble by 14 per cent and the Bloomberg-JP Morgan Asia Dollar index, which tracks the 10 most active emerging Asian currencies, currently stands at a 19-month high. This is creating what some are already calling a “capital bonanza” on offer in emerging markets, a bonanza driven by ultra-low interest rates in the developed world and rising interest rates elsewhere, as one emerging economy after another starts to feel the inflationary strain produced by growing at record annual rates. At the heart of this process is a fundamental reassessment of the creditworthiness and prospects of emerging, versus developed, economies. The developed economies are seen as having ageing work-

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forces, and being weighed down by excessively high levels of both public and private debt, while the emerging markets are seen as youthful, and significantly under-leveraged. The result is the arrival of large quantities of comparatively cheap capital for many parts of the developing world, with the implicit danger that this welcome boon could turn into a dire perill if the volume became too large, producing overheating, excess inflation, overvalued exchange rates and widespread structural distortions in their fragile manufacturing bases. In addition they could be subject to extreme volatility should what Nouriel Roubini has called the “wall of money” eventually retreat in the wake of some sort of seismic event in one or more of the developed economies.

Russia’s Ongoing Policy Dilema – To Float Or Not To Float, That Is The Question! As the IMF point out, the policy challenge posed by easy monetary conditions is greater in economies — primarily emerging markets Russia’s Andrey Klepach: Not ready to float yet... — that, in addition to strong growth prospects, have fixed or managed exchange rate regimes. Russia is a prime example here, since the ruble is maintained within a comparatively narrow trading band, while policy makers still lack a coherent policy with which to approach the problems this produces (see Russian Roulette, last issue). The central bank is keen to be proactive, and may well allow the ruble to strengthen more than the government is happy with as it attempts to balance its “free float” objective with political pressures to hold the currency down in support of the export sector. The ruble has now gained around 6 percent this year against the dollar/euro currency basket, but is still considered by many analysts to be significantly undervalued given the current oil price – possibly by as much as 25 percent. On the other hand Russian manufacturing industry is suffering from a massive loss of competitiveness, and the existing structural distortions will only be made worse by a further revaluation. The bank, on the other hand, may allow a ruble appreciation to keep a lid on import prices and help contain inflation. At the present time it certainly seems as if the central bank is committed to implementing moves towards letting the ruble float. On the other hand, in its ongoing attempts to stimulate domestic lending and support internal demand, Russia’s central bank has been systematically loosening monetary policy, and has now cut the benchmark interest rate by 5 full percentage points since last April, bringing the current rate to a record-low of 8 percent after inflation back eased to a low of 6.5 percent in March, the slowest pace since July 1998. Even after the cuts however, Russia’s benchmark rate remains significantly higher than India’s 3.75 percent reverse-repo rate, China’s 5.31 percent lending rate and is far far above the 1 percent on offer in the euro region and 0.25 percent in the U.S., attracting investors in search of higher relative returns to Russia. Not ready yet to move to a floating currencybank hasn’t stopped responding to government pressure to conatin ruble appreciation, and bought a net $14.5 billion in March, the biggest dollar purchase in five months, compared with $6.7 billion in February and $1.6 billion in January. Most analysts currently consider that the most likely option in the short term is some sort of “dirty float” whereby the central bank intervenes from time to time to correct what are regarded as excesses. However the scale of the interventions which might be needed to make such “corrections” mean they may be extremely difficult to carry out in practice. According to Deputy Economy Minister Andrey Klepach, Russia “isn’t ready to move to a floating curren-

GLOBAL EXCHANGE cy,” since the economy remains “insufficiently diversified” and is “unprepared for a full-fledged floating exchange rate.” However despite some recent intervention reserves have been recovering, and stood at $448.6 billion in the week through April 9, compared with $383.9 billion a year earlier and $515.4 billion in the second week of April in 2008, according to central bank data .

India’s Infrastructure Deficit Driven Inflation Surge Although India’s central bank have now raised interest rates twice in the last month, as well as raising bank cash reserve requirements, most observers still feel there is more to come, since India now has the fastest inflation rate of any G20 country. At its last meeting the Reserve Bank of India (RBI) raised all three key policy rates by a quarter point – taking the benchmark repurchase rate to 5.25 percent and upping the cash reserve ratio to 6 percent from 5.75 percent – although Governor Duvvuri Subbarao stated that while inflation was considered to be worrisome, “supportive liquidity conditions” were still needed to avoid causing problems for government debt sales in the short term. To put this in context it is worth bearing in mind that new government bond sales for the coming financial year are expected to be 36.3 percent higher than for the previous one. The RBI forecasts that India’s economy will expand by 8 percent “with an upward bias” in the year in the coming year, and expects annual inflation to fall to 5.5 percent by March, down from 9.9 percent in March this year, although this forecast is “contingent” upon normal monsoon rains in the autumn and a consequent fall in food prices. The June-September monsoon rains are vital for the irrigation for India’s agriculture – and following last year’s low rainfall (the weakest since 1972) food-price inflation has now been running continuously above 15 percent since last November. This compares with a March consumer price increase in China of 2.4 percent in March, registered even as China’s economic growth continued to accelerate. In addition to potential climatic pressures on food prices India’s inflation is also the result of poor infrastructure (see India: Tighten Your Seat-Belts For A Not-So-Bumpy Ride [10] in this issue), and the country produces around10 percent less electricity than it needs, and roads, which account for some 65 percent of freight transport, are characterised by single lanes and poor surfaces, according to the government’s own reports. India is also having to come to terms with the rising cost of oil, which the country imports to meet three-quarters of its needs, and crude prices have risen around 82 percent over the past year. The move to tighten monetary policy forms part of a regional trend. This month Australia’s central bank raised interest rates to 4.25 per cent (the fifth rise since last October) and Malaysia and Vietnam have also raised rates.

Brazil’s Looming Yuan Revaluation Bonanza

Meirelles: my greatest challenge is to prevent economy from “overheating”

Brazil’s central bank this week became the first in Latin America to raise borrowing costs since the the

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start of the crisis, when it put up its interest rate to 9.5 percent, from the earlier record low of 8.75 percent. The 0.7 percent increase was more than most analysts anticipated. The resulting uncertainty about the future path of policy was only heightened by the one-sentence accompanying statement which simply stated the increase gives “continuity to the process of adjusting monetary conditions to the economic outlook, so as to assure the convergence of inflation to the target trajectory.” The most recent weekly central bank survey suggested that the economists consulted forecast thatpolicy makers would lift the rate to 11.50 percent by the end of the year, but this forecast may now be far too conservative. Brazil’s economy is forecast by the bank to grow 5.81 percent in 2010 – the fastest pace over two decades, driven by domestic demand and commodity exports, but this faster growth is expected to stoke inflation which may hit 5.5 percent this year, well above the central bank’s 4.5 percent

In addition to the evident pressure China is under from the United States, the country is now facing growing pressure from other developing countries to begin appreciating its currency. Both Indian and Brazilian central bank presidents have made quite forceful statements in favour of a stronger Chinese currency. Brazil’s Henrique Meirelles has said that a stronger Chinese currency is “absolutely critical for the equilibrium of the world economy” inflation target. Indeed, the consumer price index rose to a 10-month high of 5.17 percent in March, making for the third consecutive month that the index exceeded the central bank’s 4.5 percent target. Central bank President Henrique Meirelles acknowledged earlier this month that his greatest challenge is to prevent Latin America’s biggest economy from “overheating” as increasing domestic demand fuels and GDP grows like never before. The surge in industrial output, retail sales and job creation this year have all helped produce rising business and consumer confidence. The recent decision to leave the benchmark rate unchanged (at a record low 8.75 percent) surprised many analysts, although Meirelles has now signaled he may increase the Selic rate by a half point at the April 26 meeting. Most traders are more aggressive in their outlook, pricing in a 75 basis point increase, and 2010 GDP forecasts of over 6 percent are not uncommon. Brazil’s real has been the best performing emerging-market currency in the past year, and the outlook is for it to register gains of anything up to 10 percent by July as the central bank continues to raise interest rates to stem inflation, making expectations of a year-end 1.6 per dollar parity far from outlandish at this point, with higher commodities prices, growth in China and the investor move out of developed economies all adding to the carry incentive. Attempts by the central bank to stem the tide by buying dollars in the spot market seem to have proved to be totally ineffective, and indeed estimates suggest that these purchases could cost the country something like $20 billion a year given that the cost of issuing Brazil government debt is well above the interest the bank earns from holding U.S. Treasuries. Last week the Brazilian government sold a total of $787.5 million of bonds due 2021 with a yield of 4.875 percent or 115.6 basis points more than the bank would earn by holding similar-maturity U.S. Treasuries. The key policy headache here is that increasing the interest differential with the Federal Reserve open market funds rate may well only precipitate more overheating and more inflation as the win-win dynamic of an appreciating currency and higher yield differentials attracts investors in ever greater numbers. Perhaps the single most revealing detail in this case is that during April, the month when bonds spreads widened all across Southern Europe, the cost of protecting Brazil bonds, ranked BBB- by Standard & Poor’s, from default for five years fell seven basis points to 123 basis points, according to data compiled by CMA

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DataVision. As S&P analyst Sebastian Briozzo said, “If you look at the European economies, they’re clearly credits in decline and this is a credit on the rise.”

Will Chinese Policy Decisions Pull The Trigger Or Blow The Fuse? In addition to the evident pressure China is under from the United States, the country in now facing growing pressure from other developing countries to begin appreciating its currency. Both Indian and Brazilian central bank presidents have recently made quite forceful statements in favour of a stronger Chinese currency. Speaking at the recent G20 meeting, Henrique Meirelles, head of the Brazilian central bank, said that a stronger Chinese currency was “absolutely critical for the equilibrium of the world economy”, adding there were “some distortions in world markets, one of them is a lack of growth and another is China”. At the same time Duvvuri Subbarao, governor of the Reserve Bank of India said that an undervalued renminbi was creating problems for countries, including India. “If China revalues the yuan, it will have a positive impact on our external sector,” Mr Subbarao said. “If some countries manage their exchange rate and Subbarao to China: Revalue your *#^+*€*” currency! keep them artificially low, the burden of adjustment falls on some countries that do not manage their exchange rate so actively.” However, despite the virtual unison in urging this eventuality, the impact of a renminbi revaluation may actually turn out to be a far be more complex phenomenon than most observers seem to be assuming. One good example of the kind of perverse consequences we may expect to see was offered recently in a research note from Alexandre Schwartsman (Banco Santander, Brazil) entitled “What Do You Yuan?” Schwartsman claims to offer no special perspective on whether or when Chinese authorities will decide on the issue, instead, what he looks at is the way any eventual decision may impact on Brazil. In his view direct effects through the trade channel are the not most important part of the story. True, China has become the largest market for Brazilian exports, even though it still only represents 13% of total Brazilian exports (which are equivalent to about 12% of Brazilian GDP). For Schwartsman, the main transmission channel of Renminbi revaluation to Brazil is likely to be through commodity prices. In effect he argues that a stronger yuan should imply higher commodity prices in dollar terms since, if dollar commodity prices did not change in response to a stronger yuan, there would be excess demand for commodities, which would eventually drive their dollar prices up. The economic intuition which lies behind Schwartsman’s argument is really very simple, but the logic is also quite compelling. Basically, it depends on two points: i) China domestic demand growth is more energy intensive than the OECD average ii) China is large enough to be (to some extent) a price setter, and not simply a price taker. Put another way, the income elasticity of energy consumption in China is greater than it is in the developed part of the “Rest Of the World”. This also applies to the energy component of agricultural produce, with important positive consequences for countries like Brazil. That is to say, China consumes energy

GLOBAL EXCHANGE both directly, and indirectly, via the energy input which goes into the food production (fertilizers for soya beans in Brazil, for example) that it outsources. So there is a direct, and an indirect impact. The net consequence of this, is that the Santander analyst expects the dollar price of commodities like oil to rise sharply on the back of any significant yuan revaluation, making China richer (in relative terms), and logically the developed world poorer. Again, and put in other words, the terms of trade are about to change against Europe, the US and Japan, and possibly bigtime, as the Yuan and other emerging

We are left with two big unresolved questions. In the first place: will the BRICs and other key emerging economies have suffient institutional and structural flexibility to handle the pressures and policy issues posed by these accelerated fund inflows? And secondly, will this apparently virtuous circle of cheap funding be thrown into reverse gear at some point by a financial event of sufficient magnitude to break financial market participant enthusiasm for assuming all that added risk market currencies rise. On the other hand, Brazil and other resource rich emerging economies stand to benefit, equally bigtime, in what could become one of the most significant “rebalancing operations” the global economy has seen in many a long year. The main losers, it seems to me, will be the long-term structurally unemployed we now have in the developed world, and those living in poor countries with few natural resources.

The Outlook Ahead: A More Balanced Or A More Unstable World? The current global picture is, thus, a rather complex one, with ageing and indebted developed economies struggling to find growth through deleveraging and exports, encumbered by large fiscal deficits which badly need correcting. On the other hand, relatively under-indebted emerging economies make attractive propositions for investors who are wary of buying too much first world debt, and are lured by the added returns offered by currency appreciation and interest rate increases. However, as the IMF says, the strong rebound in emerging market portfolio inflows that is currently taking place, while in and of itself welcome, does raise concerns over inflationary pressures and potential asset price bubbles in receiving countries. As the Fund says, while there is little evidence at the present time of sharply stretched valuations – with the possible exception of some local property markets (in China, for example, see China, The Megatrillion Question [11] in this issue) – current conditions of high levels of external and domestic liquidity together with the accompanying rise in credit growth do have the potential to inflate bubbles and distort economic development when considered over a multi-year horizon. In this situation there are a number of possible policy tools available. First on the list is evidently the facilitation of exchange rate appreciation, but to that can also be added using liquidity management operations to mop up domestic liquidity as well as a prudential use of regulatory tools (like loan to value criteria for mortgage lending, or disposable income to the capital value of loans) to restrict bank ability to fuel credit booms. In cases where economies are clearly starting to overheat the pre-emptive generation of sufficiently large fiscal surpluses is also highly recommended. At the same time, in strong growth economies where excessive exchange rate apreciation could easily produce distortions in fragile emerging industrial bases, the Fund also mentions the possibility that some form of capital controls could form part of the overall macroeconomic policy mix. However, the

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evidence for succesful use of capital controls is not, as the fund note, encouraging. The tax on portfolio investment introduced in Brazil in October last year, has done little to stem the rise in equities and in the real. And although the Chinese adminsitration recently placing restrictions on bank lending for third homes, the fruits of this policy still remain to be seen. Meanwhile Hedge Funds and other institutional investors seem to be decided, and are leading the charge out of developed country instruments and into emerging markets. Brian Baker, chief executive officer Asia for Pacific Investment Management Co (PIMCO) recently advised investors to buy emerging- market debt rather than developed country bonds due to the fact that the advanced economies are poised for an extended period of slower growth. “This all leads to a shift away from growth being driven by the G3 countries to a more balanced economic world,” Baker told the recent FundForum Asia conference. “Investors need to recognize that the investment opportunities are not going to necessarily be in the U.S., the U.K and Europe any longer.” In an environment where the IMF now forecast that emerging economies will grow by 6 percent this year, while advanced economies are only expected to grow by 2.1 percent (following a 3.2 percent shrinkage) in 2009, the move is understandable. And indeed the ongoing rise in some of the major emerging economy currencies will eventually facilitate the transition to what will become Bretton Woods III. But, in the meantime, we are left with two big unresolved questions. In the first place will the BRICs and other key emerging economies have suffient institutional and structural flexibility to handle the pressures and policy issues posed by these accelerated fund inflows? And secondly, will this apparently virtuous circle of cheap funding which facilitates the purchase of a growing volume of developed economy exports be thrown into reverse gear at some point by a financial event of sufficient magnitude to break financial market participant enthusiasm for assuming all that added risk. Unfortunately we may not have to wait that much longer to receive an answer, as debt funding dynamics in Southern and Eastern Europe simply seem to get more and more complicated with every passing day. Certainly at this point we can simply watch and wait, in the hope that the huge cloud of volcanic ash which was recently making its way slowly across the Atlantic and towards Europe, was simply that, a cloud of volcanic ash, and not some portent or symbol for events yet to arrive.

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Donâ&#x20AC;&#x2122;t raise taxes, spend less! .................................................... By Juan A. Hervada

Throughout the developed world all governments basically face the same problem: an aging population and rising health care costs mean more spending and less income. Hence the problem of rising indebtedness. Of course, not all countries face the problem to the same degree. Some have done their homework when it comes to having children, and will age far less rapidly than others. But here even the best case scenario means making significant adjustments. The solution to the modern fiscal dilemma will surely have to come from finding ways to spend less because taxes can be raised only to a certain point before they start doing serious damage to the economy. That can become even more problematic in the countries where there is an overgrown bureaucracy of government employees with jobs for life, such as you can find across Southern Europe. To increase your revenue by fiat, as governments can do within certain limits, is always more attractive than working hard to spend less. So it comes as no surprise that politicians around the globe spend their time trying to find that magical number for maximum fiscal revenue that will still allow them to win the next election that is somehow always pending (leaving aside places like North Korea or Cuba, where the governing party always scores over 95% of the vote, no matter what.) Traditionally, the most effective way of adding to revenue without sending voters charging off into the arms of the opposition, and tax-payers into systematic avoidance, has been a well calibrated value-added tax (V.A.T). For governments, taking a percentage of the value added at each stage in the production chain is politically less chancy than hiking taxes on income. The first benefit of V.A.T. is avoiding a general debate on how to share the burden and, inevitably, the justifiability of the burden; the second advantage is that people tend to incorporate V.A.T. into the price of whatever good or service they fell like buying, and it doesnâ&#x20AC;&#x2122;t hit them once a year as a percentage of all that hard-earned income. The other side of the coin, however, is that

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V.A.T. inevitably brings with it some element of price inflation. It also tends to bolster the ranks of the enforcing bureaucracy, and leads one economic sector after another to advance its own special case for preferential rates and exemptions. One simple general rule in a free economy is perhaps the most decisive argument against raising taxes: more government spending is a constant drain on resources that could otherwise be used to further innovation and developing new businesses. As Francisco Cabrillo likes to put it: “The best reason for not giving more money to the government, any government, is that they’ll spend it.” To the last cent and beyond. A feasible combination of revenue increases and spending cuts involves putting together an honest budget and renouncing fiscal policy as a tool for the redistribution of wealth. Governments should concentrate on providing an efficient service to citizens, without trying to use their spending as a lever to control the economy. Fiscal balances are always easier to achieve when governments are willing to rein-in their boundaries, and ideally target a modest surplus rather than a manageable deficit.

How to make things worse in a crisis Conventional wisdom on the left is that to cutting government spending is tantamount to social injustice. A fair share of professional politicians, whether on the Right, Left or Center, view it as political suicide. All in all, utopian and cynical politicians alike are prisoners of the same wharped pork-barrel logic, which can seem to be (it is not) acceptable in times of economic bonanza, but becomes self-destructive in times of crisis. Hand-outs and subsidies, when they become a way of life for a sizable part of the productive-age population, as we can see these days in Spain and other Southern European countries, can turn very rapidly into a self-feeding (and self-defeating) mechanism that has a devastating effect upon the economy, particularly in terms of job destruction. The reason is not that some people may decide to give up work because they aspire to perpetually live off subsidies and other forms of communal compensation; such people are normally a tiny minority, at least as long as not working hasn’t become socially acceptable and, of course, as long as the compensation isn’t more than what the entitled person could expect to make if he or she found a job (more about this below). The real problem is that, in an economic environment of severe crisis, an excessive level of social expenditure translates fatally into a mechanism for generating even more unemployment. At the beginning of a recessionary cycle, when joblessness starts to become a perceivable social problem, governments tend to have a knee-jerk reaction to spend its way out of the problem, wrongly considering joblessness itself as the problem to be solved. It is not. The real problem in a crisis ridden economy is that it destroy jobs, and this can be for a number of reasons. Of course, if businesses are forced to close their doors and people end-up losing their jobs, then naturally fiscal revenue shrinks, while expenditures to pay for all the joblessness simply grows and grows. To cover the deficit, the government issues a given quantity of sovereign debt, which, again, conventional wisdom considers a safe investment, particularly when there is a crisis going on, with all the accompanying risk aversion. Banks and institutional investors buy sovereign paper (which is regarded as a safe bet) and feel even less inclined to take a chance lending to businesses; the government in fact “crowds out” the companies from the credit market. In a crisis situation, one of the worst calamities that can happen to an economy is a credit crunch; starved for credit, companies go out of business and many more

GLOBAL EXCHANGE people get fired, sending more and more over to join the dole queue. These new claimants must then receive compensation, forcing the government to issue yet more bonds, which then will be duly bought by the banks etc. And so on and on, until one fine day the government wakes up to the unsavory news that it has a sovereign debt problem, and that the market will no longer accept its paper at any price in any quantity. Then it finds it has to pay more and more interest for the money it needs to borrow, and the real cost of keeping food on the table of the jobless increases by the day.

The worst case scenario In a second, deeper stage of the crisis, another collateral problem can appear. As we said before, the people who decide not to work and live on the back of the government are a minority as long as what he or she gets from the government is less than the salary that could reasonably expect in case of getting a job. Now, if the crisis deepens and pressures the salaries down, living off subsidies can become an increasingly attractive option, particularly if the money from the compensation is complemented by working in the “informal economy.” This seems to be a growing problem in a country like Spain right now, and the government looks as if it has chosen not to intervene, tacitly recognizing its powerlessness and its failure to manage the economy in the crisis. That may be a very dangerous choice. While nobody knows for sure how many Spaniards are employed under the table and how much money is circulating off the books, the consequences of what amounts to throwing one part of the economy over into illegality can, in the middle and long run, be dire. Apart from favoring the growth of the criminal networks who cater for the associated under-the-table services, from financing to protection, many solid and professional small businesses may soon find themselves unable to compete with their irregular but cheaper colleagues. This pushes more and more small companies fiscally underground, again, eroding the government’s ability to collect enough revenue.

Only one way out: spend less An wide array of the most socially advanced countries, from Scandinavia to Canada, have achieved staggering fiscal adjustments; think of Canada, which was able in the 1990s to cut the federal government spending by 20% in five years. It is not a coincidence that those countries have managed to navigate the crisis much better that the profligate Southern Europeans or the United States where the administration seems intent on playing out a remake of European social democracy in the 1970s or, worse, the clumsy French bureaucratic latter day dirigisme. The core component of the policy recipe that seemed to work for the Scandinavians and Canada involved reducing outgoings by first defining a minimalist core of “untouchable” items and then assigning a ruthless taskforce to analyze one-by-one the viability of retaining each of the expenditure items remaining. After carrying out this process systematically concocting a sensible, thrifty budget wasn’t perhaps a breeze, but the outcome was a lot more effective than before and the technical quality of the results achieved was dramatically improved.

Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=214

INFRAESTRUCTURE LOGISTICS PLAN

THE COMMUNITY OF MADRID, THE GREAT LOGISTICS PLATFORM IN THE SOUTH OF EUROPE Located in central Spain, the Community of Madrid is a unique and strategic location for the development of logistics activities, both nationally and internationally, with direct connections with North Africa, Southern Europe and Latin America. For this reason, with the idea of encouraging regional growth based on knowledge economy, the Community - with the most important logistics agents (public and private) - prompted the creation of the first large regional logistics cluster, the Logistics Platforms Association (MPL), which currently has 90 partners with national and international deployment. . Madrid Logistics Platform: Objectives . More than 120.000 jobs in the Region . The new Silk Route . Madrid in numbers

EURO ZONE

Angela Calling (the Shots?) By Edward Hugh

Angela Merkel is a Chemist. In her doctoral thesis – entitled “Untersuchung des Mechanismus von Zerfallsreaktionen mit einfachem Bindungsbruch und Berechnung ihrer Geschwindigkeitskonstanten auf der Grundlage quantenchemischer und statistischer Methoden” – she demonstrated herself to be a thoroughgoing expert when it comes to analysing the speed of disintegration of chemical compounds once the bonds which hold them together are weakened. Unfortunately she is now having to apply all this acquired expertise and know-how in a determined attempt to avoid the break up and falling apart, not of a highly complex chemical substance, but of an even more complex economic and political one, and the bonds which are the focus of all her attention right now are not chemical, but financial and social. The problems we in Europe all now face together (”wir teilen ein gemeinsames schicksal” in M. Trichet’s words) have not arrived just “suddenly one springtime” as it were, indeed they come from afar. Right from the very begining it has been no easy matter for German society to achieve the consensus necessary to accept the idea of participating in a common currency, the Bundesbank has long maintained its by now well-known reservations, while not a few have been the voices expressing the view that having so many diverse countries all sharing the same monetary unit would inevitably create a structure which was too unwieldy to be manageable, and too weak to hold together when the real storm weather came. What was needed, it was argued, was a two, not a one, speed Europe.

EURO ZONE Unfortunately, all these simmering issues have once more resurfaced during the last week, over the tricky question of what to do about Greek financing needs, and Germany’s economic and political leadership now seem to be locked in an intense debate about exactly which path to take. Meanwhile Greek bond spreads simply work their way onwards and upwards, while capital flight from Greek bank deposits has forced the banks themselves to go rushing to the government for a further 18.000 million euros in funding just to keep them alive. Despite the fact that a bailout agreement has now been reached between all the relevant parties, progress was effectively deadlocked for some weeks due to the inability of the Germany to agree with her other European partners something so apparently straightforward as the precise rate of interest to be charged on any loan to be provided. Ironically it was this single issue which brought European deciWell, I’m afraid we got a little accounting glitch here... sion making to a dead halt, creating a level of uncertainty and debate of such intensity that could eventually bring the very future of the Euro into question. And it was not a trivial matter, since the rate charged will become a precedent, which other, larger, countries can refer to later. Essentially the problem is this. According to the US economists Carmen Reinhardt a Ken Rogoff (in a widely quoted paper Growth In A Time Of Debt [4]) a potential tipping point exists once government debt breaches the 100% of GDP level in the aftermath of a financial crisis. After this point the impact of additional state spending is, paradoxically, to effectively reduce growth (given the weight of interest repayments, and the additional risk price charged for lending, and the impact of more government debt on investor confidence) and indeed far from helping a country to recover, further borrowing may mean the economy actually shrinks rather than grows.

Let’s take an example Imagine Greece has debt at the 100% of GDP level (in fact it is somewhat over 115%), and the price investors charge for buying the bonds is around 6% (or more or less 3% more than the German government has to pay to sell equivalemt debt). Now let’s also imagine that Greece has zero inflation and zero growth (they are in the midst of a massive correction which will last some years, so these are reasonable, and indeed possibly even optimistic assumptions). Then Greece will need to produce what is know as a “primary surplus” (or difference between current spending and current income) of around 6% just to stand still, and not see its level of gross indebtedness increase. But Greece, in 2009, had a primary deficit of some 7% of GDP.That is to say, simply to not get more in debt Greece has to withdraw something like 13% of GDP in demand from the economy, and this is massive, which is why all the experts anticipate a

EURO ZONE sharp contraction in the Greek economy over the next 3 or 4 years, and why rather than looking to domestic demand the Greeks will need to look to exports for support (The US economist Charles Calomiris has an excellent detailed explanation of all this here [5], while Peter Boone and Simon Johnson dig even deeper here [6]) . Which is where the European Union comes in. Basically, if Greece has to pay such a high interest rate differential to support such a large debt there is every likelihood she will not be able to continue to finance herself, and default will become inevitable. You can only demand so much effort from the reformed alchoholic before they are driven back to drinking in frustration. On the other hand the EU could help by making the interest rates charged even cheaper, but unfortunately there is a 1993 decision of the German constitutional court which makes it effectively illegal for the German government to participate in such a highly subsidised loan. And the quantity Greece actually needs is massive. Initial reports spoke of a total loan of around 25 billion, but this has turned out to be far from enough. 110 billion euros will surely be sufficient to keep the markets quiet for the time being, but am I the only one who is asking: just how are they ever going to be able to pay all this money back? And remember, we are not talking about fancy theories here, all of this is all simple arithmetic: either Greece got a large, reasonably cheap loan, or she would have defaulted. Naturally, if Greece were to do the “honourable thing”, and leave the Eurozone and default, “all would be light”. But they won’t, and there is no good reason why they should do so. Now, enter Professor Starbatty of Tübingen University [7]. He has another proposal. Not Greece, but Germany should leave the Eurozone, and go back to the Mark. And before you start to laugh, you should bear in mind that he is very serious in his proposal, and many Germans agree with him. Indeed so seriously does Angela Merkel take the possibility that any cheap loan to Germany will encourage supporters of Professor Starbatty to go to the Constitutional Court and ask for a ruling that German participation in the common currency is illegal that she has frozen the whole Greek bailout process. And it is not clear, at this stage what the view of the Bundesbank [8] is. According to German press reports, accepted by the bank itself [9], the Bank has been considering an internal report on the rescue loan proposal which states “This agreement of the heads of government, which according to our knowledge has been reached without any consultations from central banks, implies risks to stability that should not be underestimated,” (my emphasis). And before anyone complains that the Germans are too dependent on exports to the South of Europe to do anything which makes selling these more difficult, please consider that domestic demand growth in all four Southern European members of the Eurozone is expected to be extremely weak over the next decade, while growth in emerging markets like India, China, Brazil and Indonesia is predicted to be massive. The markets are moving, so why not move with them?

EURO ZONE Of course, none of this means that the Eurozone, like one of those chemical compounds Angela used to study, is about to fly apart. But we should not underestimate the stresses the currency union faces at this point. As former IMF chief economist Ken Rogoff pointed out in the Financial Times this week, “if investors gather with enough sustained force, and if the central bank lacks sufficient resilience and resources, they can blow out a fixed exchange rate regime that might otherwise have lasted quite a while longer.” What the countries in the South of Europe need to give the Germans right now are not arguments about how they would be foolish for them to leave, but arguments about what they themselves are prepared to do to make it more attractive for them to stay. The German giving machine is all done (and especially after the latest loan), and the Germans themselves are now more than tired of being continually told they need to pay, pay and pay again for events that now took place over half a century ago. Calling, Berlin, calling Berlin, hello, hello, is anybody there? Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=19 [4] Growth In A Time Of Debt: http://terpconnect.umd.edu/~creinhar/Papers/RR%20Debt%20and%20 Growth-01-18%20NBER.pdf [5] an excellent detailed explanation of all this here: http://www.economics21.org/commentary/painful-arithmetic-greek-debt-default [6] Peter Boone and Simon Johnson dig even deeper here: http://baselinescenario.com/2010/04/06/greeceand-the-fatal-flaw-in-an-imf-rescue/ [7] enter Professor Starbatty of Tübingen University: http://www.nytimes.com/2010/03/29/opinion/29Starbatty. html [8] Bundesbank: http://www.news.com.au/business/breaking-news/germany-wary-of-greece-bailout/storye6frfkur-1225851696299 [9] accepted by the bank itself: http://blogs.ft.com/money-supply/2010/04/08/bundesbank-mumblings/

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Angela Merkel:

A Lame Duck Running Wild ................................................. The markets have raped Angela Merkel twice. She is determined that there will be no third time – no matter what the cost, and no matter who has to suffer. This determination will be very dangerous for the Euro. And for Spain. Most presidents become a lame duck some day. In the last months of their last term, and especially in the days after a lost election, when they are still in charge, but by Detlef Gürtler bound to leave. With Angela Merkel it’s different. She started as a lame duck: the first six months of her second term as German Chancellor saw no ground-breaking reforms, no harsh decisions, nothing that could have upset the German voters, especially in NorthrhineWestphalia, the most populous of the German Länder. Today the regional elections in Northrhine-Westphalia are held; so tomorrow Angela Merkels lame duck period is over. And the world will soon notice. Especially the Eurozone. And Spain. During recent months Angela Merkel has had a dose of what normally happens to lame ducks in turbulent times: she was overrun by a stampede of events that simply didn`t want to wait until after her oh so important regional election. And especially in the last weeks the financial markets took her by force. They saw her reluctance – and attacked. She had to agree to the Greek bailout exactly at the time she wanted to avoid it: this week. Yes, it was some kind of rapture, and she will have promised herself that something like that shall never happen again. It’s not the first time that the German chancellor and leader of the right-wing CDU party was treated this way by the financial markets. The first incident happened at the last weekend of September 2008. These were the days, when the German Hypo Real Estate Bank (HRE) was about to collapse. Someone had to bail this bank out, and this someone had to do it quickly, before the Tokyo Stock Exchange opened in the first hours of Monday. Merkel didn’t want the German taxpayer to be this someone – the German banks should pay for their fallen colleague. But the banks couldn’t do it: It was just two weeks after the Lehman collapse, if they would have swallowed an unknown, but in any case huge amount of HRE losses, the financial markets would have lost all the faith in the German banking system, and within days or hours all German banks would have fallen like dominoes. So it was Merkel’s turn; and at the end of the weekend, in the witching hour and only minutes before the deadline, she decided to bail out the HRE. That was some kind of rapture, too, and she must have promised herself that something like that should never happen again. The HRE bailout must have been the moment, when Merkel decided, that for the German chancellor it could not be enough to make good politics for Germany – but to bring good politics to the world.

EURO ZONE Three months later, in her speech at New Year`s Eve 2008/09, Merkel for the first time ever put Germany as a benchmark for other countries: “The principles of the Soziale Marktwirtschaft must be respected all over the world. Only that will lead the world out of the economic crisis.” The chance of the financial crisis would be to convince the world of the superiority of the German economic system. Obviously, the world didn’t care too much about Merkel’s mission. As it was clear to see, neither the financial markets nor the Greek government adopted the system of Soziale Marktwirtschaft. Instead of pilgrimaging to Berlin both followed their traditional paths of reckless behaviour. And managed to make their living on the expense of Germany. So guess what happens if the next country knocks on the door of the Eurozone begging for shelter and money, the bloodhounds of the financial markets on his heels? Merkel will keep the doors shut; and if the rest of the Eurozone tries to open it against her will, Germany will leave through the back door and return to its still beloved D-Mark. Yes, they do still love their D-Mark. The Germans only accepted the Euro because they were told the new European currency would be more or less the same as their old national currency. With an independent central bank only committed to price stability, and all member states of the Eurozone on the same path of low inflation and modest public debt. With a German-like currency the rest of the Eurozone countries would sooner or later become German-like economies. And indeed: The design of the Eurozone doesn’t think of different economic cultures, it thinks of one European way of running an economy. But that wasn`t true at the time of the Maastricht treaty (1992), it wasn`t true when the Euro came (2002), it isn`t true today – and it doesn’t seem to become true in the ongoing crisis. So, the Eurozone didn’t care too much about German dreams. Some countries, especially in the South, took advantage of the historically low Euro interest rates, piled up huge amounts of public debt (like in Greece) or private debt (like in Spain), consumption rose, competitiveness fell. Germany meanwhile went through a structural crisis in the first euro years and solved its problems in a hard, German way: cutting labor costs and social welfare, raising productivity and exports. While the interest rate converged, the economies diverged. Let’s take Spain for example. Spain with

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interest rates as low as Germany didn’t become a second Germany, but a Spain on speed. And now, as Spain has fallen into a structural crisis, it’s obviously unwilling to choose the hard, the German way to get out of it. The economic cultures of these two countries are way too different. That’s no problem, as long as Spain finds enough investors in the financial markets to finance its debts. It`s a serious threat for the Eurozone, if not enough buyers show up, or if some players in the financial market start an attack against Spain. For Angela Merkel, the most important reason for the Greek bailout was the rescue of the Euro. That reason is shared by most of the German companies, as the common currency makes crossborder trade easier and cheaper, and about two thirds of German exports go the Euro countries. The German people rate that remarkably different. For them only a strong Euro is a good Euro. The Greek bailout was highly unpopular in Germany and a complaint against it will soon be judged by the constitution court. In 1993 the same court ruled that the Eurozone mustn’t become a “transfer union”, pumping subsidies from the rich to the poor countries. The judgment this time might come too late to stop the money for Greece – but early enough before the next candidate is due.

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Building Hedges Around Greece? ............................................................ by Claus Vistesen

While Macro Man opted [1] to present a po(p)etic styling on the ongoing hardship in Greece (or was that Grease?) today came with a couple of notable developments in the story and would seem to be honourable and real efforts to calm down markets. Obviously, it is difficult to tell whether this is a true attempt to save Greece from what increasingly looks inevitable or whether it is an attempt to make sure the debacle does not turn out to be a Eurzone rout. In any case, action it seems is entering the stage on the cost of fiddling. Firstly and as is customary in these kinds of situation, the Eurozone group of finance ministers [2] gathered Sunday to approve the whopping € 110 bn aid package which had been rumoured last week. Euroregion governments are betting 110 billion euros ($146 billion) in economic medicine for Greece will be enough to inoculate the rest of their region from contagion. (quote Bloomberg) Finance ministers approved the unprecedented bailout yesterday for Greece after a week that saw the country’s fiscal crisis spread to Portugal and Spain. At the same time, they refused to say how they would help other indebted nations if the need arose, calling Greece a “special case.” The risk is that investors will shift focus to other euro nations in the absence of a clear aid plan for the 16-nation bloc’s weakest members. The extra yield investors demand to buy Portuguese debt over German bunds surged to the highest since at least 1997 and Spain’s IBEX 35 stock index fell the most in three months last week. The euro fell against the dollar today. “It is far from assured that this program will forcefully counter contagion risk,” said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co. in Newport Beach, California, which runs the world’s biggest bond fund. “Heavily exposed creditors” may try to head off potential losses and sell bonds, “increasing the pressure on core European governments to also provide a backstop for Portugal and Spain.”

EURO ZONE Greece yesterday pledged to push through 30 billion euros ($40 billion) of budget cuts, equivalent to 13 percent of gross domestic product, in return for loans at a rate of around 5 percent for three years. The EU and the International Monetary Fund, which is co- financing the bailout, also agreed to set up a bank stabilization fund. With downgrades threatening to render Greek bonds ineligible as collateral for its loans, the European Central Bank today said it will accept all Greek government debt when lending to banks. Two questions immediately arise here. One is the extent to which the bailout put up front as it were is enough to avoid contagion to Spain and Portugal (or god forbid Italy). Basically, it was this very issue which raised the stakes last week as the S&P moved in to downgrade both Spain and Portugal and where markets began to play the dreaded spread game as yields on Spanish and Portuguese government debt widened alarmingly. The second is the more technical question of whether this will be enough to avoid an eventual default in Greece. This depends both on the real scale of the situation (i.e. how many more skeletons can we expect to rattle out of the closet) as well as whether Greece has the actual capacity to carry through the austerity measures demanded. I am not talking about in principle here, but more in reality and with all the practical issues of having to fight your own citizens with water canons three days a week as well as accounting for the loss of production when Greece turns to the street in stead of to the offices and factory line. I am an optimist by nature, but it looks difficult, very difficult. However, perhaps the second news coming in today might help a little bit even if it was not unexpected. Consequently and in light of the fact the Greek government bonds has long been fairing below the pedigree otherwise needed to act as collateral at the ECB (well de-facto, if not de-jure yet), Trichet and his colleagues [3] extended a helping hand today by specifically making Greek govies eligible as collateral at the ECB’s asset facilities. (quote Bloomberg) “The ECB is a key player in the rescue package designed to help Greece and it is clearly buying insurance against the likelihood of further multiple downgrades of the Greek debt, something that might lead to a halt of ECB financing to the Greek banks,” said Silvio Peruzzo [4], an economist at Royal Bank of Scotland Group Plc in London. Further downgrades from credit-rating companies had threatened to render Greek bonds ineligible for collateral for ECB loans after Standard & Poor’s last week cut the nation to junk status. Had Moody’s Investors Service and Fitch Ratings followed suit, Greece’s debt would have no longer been accepted under the previous rules, threatening to inflict further pain on the economy and its banks. This will definitely help, but it was also a foregone conclusion. Consequently, had the ECB chosen to stand aside as Greece was further downgraded by the rating agencies the yields would almost surely have risen to levels not only inconsistent with proper debt management but also ultimately to levels forcing an instant default. The point I am making here is simply that if the ECB had chosen not to do this, they would have explicitly sent the message that it is ok for the market to discriminate markedly and decisively between Eurozone debt issued by different countries and presumably, it is exactly the opposite message that they want to be sending at this point in time.

So where does it go from here. Well, to me Greece is doomed and while this may sound excessively alarmist I see no way out for this economy. The real nutbreaker will be whether Portugal and Spain are the next one to follow. One default and you blame the defaultee, three and you blame the system and it is exactly the imminent risk of the second (almost unthinkable) scenario that I recently dealt with in a more lenghty format [5].

EURO ZONE Donâ&#x20AC;&#x2122;t get me wrong, I salute the effort and I sincerely hope that the Eurozone will make it through in one piece, but at this point in time I need to be building hedges around my erstwhile optimism.

Article printed from THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=252 URLs in this article [1] Macro Man opted: http://macro-man.blogspot.com/2010/05/grease.html [2] the Eurozone group of finance ministers: http://www.bloomberg.com/apps/news?pid=20601068&sid=aBu8o1 ghvfoE [3] Trichet and his colleagues: http://www.bloomberg.com/apps/news?pid=20601068&sid=aTAygysllnxM [4] Silvio Peruzzo: http://search.bloomberg.com/search?q=Silvio+Peruzzo&site=wnews&client=wnews&proxystyle sheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1 [5] in a more lenghty format: http://clausvistesen.squarespace.com/alphasources-blog/2010/5/3/the-catch-22-ofeurozone-imbalances-fighting-the-debt-snowba.html

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Estonia’s Big Euro Gamble ............................................... By Mikk Salu - mikk.salu@epl.ee

When recession arrived in Estonia in 2008 it felt like the country had been hit by a perfect storm. On the one hand there was a severely overheated internal market, and on the other the global financial crisis and collapse of the world trade – factors which are so important for a small open export-oriented economy. The results were devastating. Estonian GDP dropped 3.4% in 2008 and 16% in 2009. And the labour market moved from full employment to a 15% unemployment rate in little more than a year. These are spectacular numbers, even more acutely felt in a small closeknit country with a population of just over a million. What was the Estonian government expected to do in such circumstances? The conventional response would have been a Keynesian-style stimulus and/or currency depreciation. And this is exactly how many countries reacted to the crisis. Of course, those Europeans who are in the Eurozone cannot devalue, so they stimulated. Those who had not adopted euro, like Sweden or Britain, did both. Estonia chose a third option. Instead of stimulating they cut government spending. Instead of devaluing, they have stubbornly kept to a fixed exchange rate (the Estonian currency – the “kroon” – is pegged to the euro). And the real economy has been left to go its own way. The name of the game is internal devaluation – an attempt to bring prices and salaries down without actually devaluing the currency. This is interesting experiment, valuable as an experience also for Greece, Spain or Ireland, because these countries are now tackling exactly the same issue – how to restore competitiveness and sort out public finances if you cannot depreciate your currency. What is involved is however a big political and economic gamble. And everything has been done in the name of one paramount goal – to achieve Eurozone membership in 2011. So far the gamble has payed off. Estonia is currently the only European country which has fulfilled those famous Maastricht criteria in both 2009 and 2010. These are criteria about the budget deficit, the inflation level and the size of the accumulated government debt, and even those countries inside the Eurozone are not able to keep pace with these Maastricht criteria right now. Despite a huge fall in economic activity the popularity of Estonia’s right-wing government has been remained stable, indeed they even have a good chance of winning the general election scheduled to take place next year, especially if they are able to deliver on their promise “We are

EURO ZONE bringing the euro!” Estonia has some advantages in this context. It is a very small and homogeneous country which makes it easier to hold together the consensus needed to execute extremely tough reforms. During the last two years the Estonian government has not just cut the budget (salaries and spending have been reduced in all public areas from Prime minister to doctors and teachers), it has also been able to pass several new laws, like the new bankruptcy law or a new labour law which aims to make the labour market even more flexible. Of course, critics will say, this will only make lay-offs easier… Only a month ago a new law governing the retirement age was passed – from 2018 onwards the retirement age will gradually rise to 67. Reforms which in some other countries would take many years, if they would ever be introduced, have been put into effect in Estonia within a matter of months. Of course, opposition to the government policy in Estonia is weak. Estonian unions are not strong, and are far from being effective. The last time they tried to organise a public protest rally, there were more journalists present than actual protesters. And opposition politicians have not been able to present viable alternative. The only reasonable alternative would have been to drop the fixed exchange rate regime and devalue the Estonian kroon. But to suggest such a move in Estonia tantamount to committing political suicide, given that the currency board and fixed exchange rate mechanism enjoy strong popular support and are deeply engrained in the Estonian economic and political system. Nobody, at least no active Estonian politician, is willing to question it. The currency board was introduced in 1992 when the decision was taken to peg the Estonian kroon to the then Deutsche Mark (and from 2002 to the euro). The initial decision was made almost a chance one. Following independence from the former Soviet Union Estonia wanted to have its own currency, but had no real idea about what to do in terms of monetary policy. Then Ardo Hansson, a young foreign-born Estonian economist, arrived and suggested the idea of a currency board. I suspect that one of the reasons why the Harvard educated Hansson supported the currency board was because he saw how little the leadership of a newly born country understood about the complexity of modern monetary policy. Thus Hansson proposed having a fixed exchange rate, because independent monetary policy would have been difficult to sustain. In 1992 Estonian representatives traveled to Germany and informed the authorities there that they had decided to peg their kroon to the Deutsche Mark. The man who hosted the delegation in Germany was the then head of the “Foreign Trade and Payments, Money and Foreign Currency, Financial Markets” of the Bundesbank. His name was Jürgen Stark. 18 years later Ardo Hansson, the man who brought fixed exchange rate to Estonia, is chief economist in World Bank´s Bejing office and one of the leading candidates to be the next President of the Bank of Estonia. Jürgen Stark is a Member of the Executive Board of European Central Bank, and a key figure decision making over Estonia’s euro application. Two weeks ago – at the closed meeting of the Economic

EURO ZONE and Monetary Committee of the European Parliament â&#x20AC;&#x201C; Stark stated that Estonia is currently not able to adopt the single currency. According to Stark, although Estonia fulfills all the Maastricht criteria, Estonia is not fit to adopt the euro, at least for now. Funny how history comes together sometimes. Those very same names who were in the forefront when the Estonian currency board system was born are now key players in the decision on whether or not to allow Estonia to join the Eurozone. Sure, the European Central Bank is probably against Estonian membership, indeed the Bank is probably against any further extension of the zone at this point. But at the end of the day the creation of the euro was a political decision, and euro adoption is also a political decision, one which is to be made by politicians, and politicians, as we all know, often see things differently from economists. So the verdict is still out there, waiting to fall. All these sacrifices, all these budget cuts, everything Estonia has done during last two years, will they be enough to get into Eurozone, or will the country fall victim to events happening over 1,000 kilometres to the south. Will Estoniaâ&#x20AC;&#x2122;s gamble pay off? Stay tuned, the decision is due to be made in July.

Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=40

EURO ZONE ~ Spain

Rough Ride for the Spanish Financial Sector ................................................................................ In the first moments of international crisis it seemed that the Spanish financial system was not going to be directly affected by the insolvency of those U.S. investment banks which were virtually bankrupt. The financial crisis was closely related, as is known, to the U.S. “subprime” mortgages and derivatives, and neither the banks nor the Spanish savings banks had, in effect, a severe exposure to such assets. But analysts soon began to be aware that Spain could not be excluded from international financial problems. First, both companies and Spanish families have a high level of debt, and it is clear that any problems that create distortions in the international financial market significantly affect the Spanish economy.

By Francisco Cabrillo

Spain has had one of the largest housing bubbles in the world Furthermore, it is not difficult to realize that the financial system of a country that has had one of the largest housing bubbles in the world, is necessarily very much exposed to possible bankruptcies of construction companies and home buyers. In other words, even though Spanish lenders might not have “subprimes” on their balance sheets in the strict sense, one could expect that many of the loans granted – especially in the real estate sector – raised serious solvency problems. It did not take, in fact, long before some banks and savings banks – especially the latter – began to experience difficulties, and the government had to create a fund to clean up financial institutions which hitherto – and quite surprisingly, given the gravity of the situation – have only been used for a savings bank, Caja Castilla – La Mancha, the only one operated by the Bank of Spain. Concern about the strength of the Spanish financial system has grown substantially in recent months. And the problem has been exacerbated by the lack of transparency with regard to the specific situation of each financial institution. For some time now there have been rumors of all kinds on certain credit institutions. If they valued their real estate assets and their loans to this sector with market criteria they would have liabilities exceeding their assets. Moreover, the economic crisis is seriously affecting many companies, which are faced with serious funding problems. There is, in effect, a credit crunch, and not only for companies with solvency problems, but also for businesses in principle solvent, but illiquid, which can not get enough money supplies to finance their ordinary operations. Banks insist that the problem is not about the supply of loanable funds, but of effective demand, since, given the recession which the Spanish economy is still suffering, many of the proposed operations do not offer sufficient guarantees to banks, basing their idea on the

EURO ZONE ~ Spain

fact that there has not been a significant credit reduction in Spain. It should not be forgotten, however, that a significant number of loans and credits granted are not new loans and credits, but renovations to companies who can not pay on time, and banks prefer to extend the loan before they are considered delinquent. Just how healthy are they? Add to this that the Spanish banks financed part of their active operations in Spain by issuing liabilities abroad, and that they have to return them to maturity in an international market in which there is a growing demand for funds as a result of budget deficits in many countries, it is easy to understand that banks and credit institutions need more resources. This has had the effect that the media has been calling the “bank war” or “passive war.” The country’s largest bank, Banco Santander, is now offering a return on deposits well above the market average, with the proviso that the funds are “new”, i.e. the aim is that savers withdraw funds from other financial institutions and put them into the new products offered by the Santander. Recently the Financial Times echoed this strategy, and noted that some credit institutions, already in serious difficulties, will not be able to compete with offers from the big banks, and a reduction of their deposits will only aggravate the problem. The strategy of the Bank of Santander, on the other hand, is perfectly logical in a market economy system. If there is excess demand for funds, it is necessary to pay more to depositors to get them. And in this sense the Bank of Spain has also stated its ideas clearly. It is necessary therefore to start the reorganization of plans for the savings banks, as soon as possible. But the fact that the credit institutions are highly politicized and controlled societies, in most cases, by the governments of the Autonomous Communities, makes it difficult to implement effective solutions. In reality, little has been done so far in this regard. The regional governments seem to be beating the Bank of Spain in this game, and the Bank does not dare to take action that would undoubtedly have important political consequences in a country where the crisis is not just economic, since it is affecting almost all the basic state institutions in a very worrying way. But are just the credit institutions that are in trouble? Or more clearly stated, can the economic crisis also affect the solvency of the two largest banks, Santander and Bilbao? Recently, some analysts have considered that the fundamental point is the behavior of the real estate sector. Nobody really knows how much those properties that are the guarantee of many bank assets or now owned by financial institutions as a result of unpaid loans can fall. Spain is among the countries that have had major housing

EURO ZONE ~ Spain

bubbles, one in which prices have fallen less. But estimates of possible further falls are very different. What is clear is that the more prices fall, the more serious problems banks will have. For his part, the Bank of Spain Governor has indicated that the major problem with credit is in the real sector of the economy, and that the main threat to its solvency is the high unemployment rate, close to 20% today of the working population. The situation is therefore complicated both for banks and businesses. And we should not forget the role that the credit market is playing in the Spanish public sector. With a deficit that â&#x20AC;&#x201C; in official figures â&#x20AC;&#x201C; last year reached 11.4% of GDP and the public debt growth accelerated, the Spanish state has become a big demand for capital. And the easiest way to place their new debt issues is being acquired by Spanish banks. This results in the reduction of funds available to finance private companies. And the situation may become more difficult as the European Central Bank tightens its monetary policy with the improvement of the main European economies. A mixed picture, therefore, in which the Spanish government continues to maintain an attitude of passivity that is increasingly striking.

Article printed from THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=98

EURO ZONE ~ Spain

Spain’s Unemployment Statistics

Brother, Can You Spare a Leak? ....................................................... Well, according to a popular urban legend, Spain’s unemployment rate – which is the second highest in the EU after Latvia – is currently running at something just a touch over 20%. Or is it?

A “technological incident” The unemployment problem I wish to address here is not the one of how to get to grips with actually putting all these people back to work, rather it is that of untangling what exactly Spain’s real EU harmonised unemplyment might be, since, to say the least of it, some strange things have been happening in recent months.

by Edward Hugh

But to start with some consensually grounded facts: The number of unemployed jumped by 286,200 during the first three months of the year – using the not seasonally adjusted labour force survey methodology – and hit 4.61 million or 20.05 percent of the workforce, as reported in the conservative Spanish newspaper ABC on Tuesday of last week [4]. And how did ABC know last Tuesday that the first quarter unemployment rate was 20.3% given that National Statistics Office (the INE) was not due to publish the official figures till Friday. Well ABC knew the number since the figure was How many are they? “accidentally” posted on INE’s web site for several minutes on Monday. The incident – which is reminicent of the Mr Bean interpolation on the EU Presidency Website at the Moncloa in January – was subsequently confirmed by the INE itself, who issued a statement baldly stating that a technological “incident” had made “certain data” from its quarterly unemployment study visible on its web site. Of course, in a country as given to conspiracy theorising as Spain is, this “technological incident” has lead to all sorts of speculation – that, for example, statistical staff at the INE (in a similar fashion to those employees in the statistical office in Argentina’s Mendoza province who rebelled against Nestor Kirchner’s use and misuse of inflation numbers) had simply gotten tired of seeing their data massaged for political objectives, and wanted to get the politically sensitive 20%+ number published before it was changed. Indeed none other than Economy Minstry Secretary of State José Manuel Campa had to come out publically to deny that anything untoward had happen. [5]. As far as the Ministry was concerned there had been no leak. “The Employment Survey data was not leaked”, he said “there was an error. There is absolutely no evidence that the information was leaked. Spanish insititutions are quality

EURO ZONE ~ Spain ones. To create doubt about this seems to me to be a major act of irresponsibility. I am convinced that mistakes can be made.” Unsurprisingly, there are many who remain unconvinced. “It is becoming clearer with every passing day that what happened was not an accident, but was a leak to try to ensure that the data was not manipulated even more,” declared the conservative newspaper Hispanidad [6]. “Fortunately”, they went on to say, “in our statistics office we still have professionals who are not willing to accept just any old methodology” . In fact, the mystery (or war of leaks) deepened even further, since data apparently leaked laterthat week by government sources to the EFE news agency [7] showed that the number of unemployed registered at government agencies (a different methodology) fell by a non seasonally adjusted 24,000 in April. The data was not scheduled for release until tomorrow (Tuesday). Now a lot of this would be none-to-worrying, and might seem like a lot of the typical to-ing and froing you tend to associate with normal political debate about unemployment, except, except…. well except that something rather strange does actually seem to have been happening, and except that, well, you know, there is rather a lot of concern around about the level of Non Performing Loans in Spain’s banking system, and the econometric equation used by both the Bank of Spain and the IMF (more on this in another post) for their stress tests, well, the assesment is based on projections about Spain’s actual unemployment rate. So there is more than just votes at stake here. [8] What, then, has been going on? Well the first thing that it is strange is the fact that the unemployment numbers do not really fit with other indicators we have, like the number of people affiliated to the national social security system – which is, if you want, a measure of the number of people actually employed. Basically since last September, when you could say that the funny things happening with Spain’s unemployment data got even funnier, a seasonally adjusted 189,000 people have stopped contributing to the social security system (by March, see above chart). This represents something like 1.06% of total employment, so, we might like to ask ourselves, how can estimated unemployment have only risen by 0.1%? Especially when, and according to the Labour Ministry’s own data [9], the economically active population has risen by a seasonally adjusted 35,000 over the last six months. Something, somewhere just doesn’t fit here.

EURO ZONE ~ Spain Especially if you look at the chart of the Eurostat data as it now stands, where it seems unemployment has been completely flat for several months. [10] Now, with the data filed at Eurostat being constantly revised, your correspondent decided to do that really tedious and tiresome thing, and go back through all the relevant press releases from Eurostat. To check for yourself you can go to this page [11], where you will find the entire file, complete with the relevant links. Here, for the sake of convenience, we will just produce two extracts, the latest (March) data, and the data for November 2009. (Please click on images for better viewing). Now, as can be seen in the November file (below), unemployment had been rising steadily at a more or less even pace since the spring, and had hit 19.4% by November, which made the sort of predictions that I personally was making for unemployment going up towards the 25% mark in 2010, if not completely scientifically valid, at least not simply wild speculation. [12] But if we now move on to the March 2010 file (below) we will see that the 19.4% level was never actually hit (in theory), and that unemployment is supposed to have peaked at around 19% of the population, and is now, of course, about to turn down. [13]

EURO ZONE ~ Spain Of course, they may have some problems with the seasonal adjustment methodology, but in which case they should say so. On the other hand, the social security affiliates data suggests a constant employment loss of around 35,000 a month for the last several months, and that the bloodletting continues relatively unabated, which means Spain is experiencing a “real” increase in its unemployment rate of around 4% a year. And if you then apply this input to a simple linear regression model based on earlier Spanish data (which gives a factor of 0.66 to apply to this percentage rate of increase), then we might reasonably expect the rate of distressed loans to go up by something like 3% this year. The IMF Global Financial Stability Report on the other hand, using face-value unemployment data (see this file [14] page 54) projects NPLs at commercial and savings banks will peak at 6.3 percent and 6 percent, respectively, in 2010:Q3, and then come down to 5.1 percent and 5 percent, respectively, by the end of 2011. That is really the importance of this whole debate, since (assuming other things to be equal, which in fact aren’t but we’ll see about that another day) if unemployment hasn’t yet peaked, then NPLs won’t peak in Q3 2010, or anything like it, as the authors of the IMF report themselves point out in their adverse case scenario. Now, there is another possible explanation for the mismatch between unemployment and job loss, and it is one that I have explored in this post here in your correspondent’s blog on the Spanish newspaper Expansion [15]: it could simply be the case that people – both young Spanish nationals and migrants – have left Spain.

Article printed from THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=286 URLs in this post: [4] as reported in the conservative Spanish newspaper ABC on Tuesday of last week: http://www.google.com/ hostednews/afp/article/ALeqM5iIfPhI4rfg0lRUbXRJm_Aa4rpTjQ [5] Economy Minstry Secretary of State José Manuel Campa had to come out publically to deny that anything untoward had happen.: http://www.elmundo.es/mundodinero/2010/05/03/economia/1272900665.html [6] declared the conservative newspaper Hispanidad: http://www.hispanidad.com/noticia.aspx?ID=135844 [7] data apparently leaked on Saturday by government sources to the EFE news agency: http://www.reuters. com/article/idUSTRE64107U20100502 [8] Image: http://1.bp.blogspot.com/_ngczZkrw340/S7Me875ECGI/AAAAAAAAQkI/0wmP7rhZvvQ/s1600/ Spain+Afiliados.png [9] Labour Ministry’s own data: http://serviciosweb.meh.es/apps/dgpe/TEXTOS/pdf/completos/sie_complet3. pdf [10] Image: http://1.bp.blogspot.com/_ngczZkrw340/S98Pwspl97I/AAAAAAAAQnI/Fhqlqp5ohUg/s1600/ unemployment+one.png [11] you can go to this page: http://economicresources.blogspot.com/2010/05/spains-unemployment-problem.html [12] Image: http://3.bp.blogspot.com/_ngczZkrw340/S97u2Tt1B4I/AAAAAAAAQmw/dTXQGeQedIU/s1600/ November+2009.png [13] Image: http://4.bp.blogspot.com/_ngczZkrw340/S98QyAg2l9I/AAAAAAAAQnY/TKNpWQXcx8c/s1600/ March+2010.png [14] see this file: http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/chap1.pdf

EURO ZONE ~ Spain

Pole Position ....................................................... I have always thought that no one ever remembers second positions. People do not remember who won the silver medal, or who the sub champions were, or who the vice presidents of this country or this company are. It is a shame but it is reality. The good news for Madrid is that no longer will they have to worry about this problem. The GDP of the Community of Madrid is superior to that of Catalonia in absolute terms, i.e. Madrid has become the first autonomous region from the economic point of view even though it has a much smaller population than Cataluña –which had held in recent years the coveted top spot. And this new milestone is not isolated or coincidental, but the result of the good work carried out by the Community of Madrid to create a trust framework where companies and workers can perform their professional work more efficiently, thus helping to increase activity and employment. And this is the view foreign investors who bet on the Community of Madrid have, as a destination for their investments, which makes Madrid the leader of these investments, with 61% of the total in the last ten years. In addition, this trust has made the Madrid Community the national leader in entrepreneurship and their subscribed capital for some years now. Moreover, Madrid has become a leader in virtually all economic indicators, from growth of per capita income, through investment attraction and business creation and culminating in GDP in absolute terms. It could be argued that the new leadership of Madrid as Spain’s most powerful economy, with GDP amounting to 211,174.5 million, followed by Cataluña’s, with a GDP of 210,853.1 million, is the result of its capital, but it is an argument that fails under its own weight. The truth is that due to the autonomous decentralization process, especially in recent years, Madrid is “less capital” than it used to be some years ago. Other regions like Catalonia and the Basque Country have developed their own regulatory bodies and policy-making centers, and ergo they have also become small capitals of our near-federal “State of the Autonomies.” In fact, many studies indicate that the Community is the only region in Spain, out of those economically important and within the common system, which is about to enter into positive growth rates, while the average in Spain is still below zero . Madrid has managed to do better in the environment of the new economy, particularly in the crisis, therefore remaining the economic engine of Spain. This improved resistance is due to the firm commitment to productive growth, to an innovative and dynamic environment that generates confidence, more companies and talent. In fact, the Community of Madrid has grown by 1.525 million people since the beginning of the autonomous period, i.e. 32.2% at a time when the fertility rate fell after the end of the baby boom during the 60´s and the 70´s. Therefore, this dramatic increase in population can only be due to the attraction the Community of Madrid has managed to generate. It is an attraction based on the confidence

EURO ZONE ~ Spain that the region has launched, where personal initiative and career development are rewarded, which has prevented Madrid from going on being a gray, bureaucratic area, the center of decision but not the center of the labor and entrepreneurial spirit that now characterize the Community of Madrid. The Madrid Community, in fact, in these recent years of consolidation of its decentralization process, has managed to seize opportunities and has opted for a less bureaucratic economy where the protagonists are the companies and entrepreneurs, and where the institutions simply provide a framework for trust. Today, Madrid can take pride in saying that those leaderships she has been attributed place her in the pole position of the most advanced regions in Europe.

Article printed from THE GLOBAL SPECTATOR: http://www.globalspectator.net URL to article: http://www.globalspectator.net/?p=118

EURO ZONE ~ Spain

What A Difference A Day Made! ......................................................... by Lucas Monteiros

According to a once famous statement by the British Prime Minister Harold Wilson, a week is often a long time in politics. But when it comes to financial market crises we seem to follow a pattern more reminiscent of a line from the Dinah Washington version of an old María Méndez Grever song: “What a difference a day made”. The day in this case was,, at least for those of us here in Spain, when the ratings agency Standard & Poor’s downgraded Spanish Sovereign In fact, it now seems that the present Spanish government appears debt to AA from AA+. As a to be becoming more and more isolated from Spain’s financial and result the cost of insuring corporate establishment with every passing day. such debt using credit default swaps (CDS) surged at one point to a record 211 basis points according to CMA DataVision prices. Contracts on Greece and Portugal also rose sharply, with Greece climbing 42 basis points to hit 865.5, while Portugal jumped 20 to 406. Standard & Poor’s justified their Spain downward revision by referring to their medium-term macroeconomic projections. In particular the agency cited heavy private sector indebtedness (of around 178% of GDP), an inflexible labor market (they expect unemployment to remain around 21% throughout 2010, but then continue at a very high level for half a decade or so), the country’s fairly low export capacity (Spain’s exports only amount to around 25% of GDP) and the general lack of external price competitiveness. All these factors they feel are likely to mean that Spain will have low growth between at least now and 2016, a factor which will make the combined burden of private and public indebtedness much harder to service. And despite the fact that Spanish Deputy Finance Minister Jose Manuel Campa stepped forward to say he was “surprised” by the move, arguing they are based on overly pessimistic growth forecasts, the fact is it is very hard to disagree with the S&P conclusions, as investors across the globe well understand. Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

EURO ZONE ~ Spain In fact, it now seems that the present Spanish government seems to be becoming more and more isolated from Spain’s financial and corporate establishment with every passing day. As Victor Mallet points out in today’s Financial Times [5], “it cannot be often that academic economists use pictures of Omaha Beach, site of the bloodiest fighting in the 1944 Normandy D-Day landings, to illustrate their conclusions about one of the world’s medium-sized industrial economies”, but this is precisely what the prestigous Barcelona-based Esade business school’s latest economic bulletin did in their “H-Hour for the Spanish economy” editorial. “The diagnosis is very serious,” they said. “This is a highly indebted country with a damaged income-generating mechanism.” Now even if one does not entirely go along with the whole analysis they offer of the roots and remedies for Spain’s malaise, there can be no doubt I’m not sure who it is the Spanish Prime Minister currently has interthat they now take the situation very seriously, preting the signs for him – it is certainly not Perdro Solbes, or David even if one could laVergara, or Jordi Sevilla, or indeed Carlos Solchaga – but it seems far ment that they did not more likely to me to be one of Spain’s renowned Gypsy palm-readers begin to do so starting in August 2007, when than any reputable and internationally recognised macro economist.. the wholesale money Miguel Angel Murado in The Guardian markets first closed their doors to the increasingly toxic products that were being issued from within the Spanish banking system. The warning signs were already there, and were plain to see, although, unfortunately few inside Spain were able to do so. As a result, nearly three critical years have been lost, dithering around, large quantities of public money have been wasted, and what was a private sector external indebtedness problem has now been transformed, little by little, into a fiscal crisis of the state. If the Spanish economy is really to be put straight, and not simply go straigh back and recidivise (after whoever it is who will do the “bailing out” finally does it), then surely one major priority during the coming national soul-searching process must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy’s “inner secrets”, and the strength of character needed to publicly recognise problems in order to be seen to address them in a proactive and not a reactive fashion – to be out there in front of the curve, and not constantly trailing behind it. Put another way, it’s high time Spain’s bank and financial anaOne could lament that they did not begin to do so starting in August lyst community finally 2007, when the wholesale money markets first closed their doors to came out of the closet.

the increasingly toxic products that were being issued from within the Spanish banking system.

And if that all important international investor confidence is to The warning signs were already there, and were plain to see, albe once more regained though, unfortunately few inside Spain were able to do so. then it is important that those in the Economy Ministry are seen to be aware of the problems they face, and not simply reduced to the role of “marketing department” for a government which finds itself in ever deeper difficulty, caught between the rock of its own voters, and the hard place of the international financial markets. If you don’t like having rating agency downgrades, then do something to avoid them before they inevitably come. But what was it Mr Zapatero was saying

EURO ZONE ~ Spain only yesterday [6], oh yes, he personally can see “signs” the Spain’s economy Spain is at long last “improving”, that the “worst is now behind us”, or as Miguel-Anxo Murado so ironically puts it in the Guardian’s Comment Is Free [7]: “all repeat after me, “Spain is not Greece””. I’m not sure who it is the Spanish Prime Minister currently has interpreting the signs for him – it is certainly not Perdro Solbes, or David Vergara, or Jordi Sevilla, or indeed Carlos Solchaga – but it seems far more likely to me to be one of Spain’s renowned Gypsy palm-readers than any reputable and internationally recognised macro economist. In fact, as I have often stressed (and as Paul Krugman makes plain yet again here [8]) Spain’s problem is not essentially a fiscal one. Spain’s problem is one of very high levels of corporate and household debt, and how Spain’s banking system is going to support these during the long economic downturn and the ultra-high unemployment the country now faces, especially as a growing number of unemployed steadily lose their entitlement to unemployment benefit. The problem is not only that unemployment is currently running at 20%, but that benefits only last two years (plus an emergency six month flat rate 426 euro monthly payment extension), while many forecasts are now showing unemployment in the 16% to 20% range in 2013 or 2014. Just how are all these people going to continue to pay all those mortgages?

Krugman: Spain’s problem is not essentially a fiscal one. So it is not simply that “public sector borrowing is aggravating external debt and leading Spain towards highrisk territory”. This is happening, as Spain’s most high profile and most strategic export increasingly becomes government and bank paper, Spain, May 2010 but this is the aggravating factor, and not the root cause. The principal reason why Spanish debt is steadily moving into high risk territory is the continuing state of denial to be found among the Spanish decision making elite, and the absence of any credible plan that is up to the magnitude of the challenge ahead. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates those banks who now anticipate having difficulty funding themselves in the wholesale money markets are offering) rather than going out and spending it.

EURO ZONE ~ Spain The real issue is to be found in the confidence (or lack of it) those who Spain and its banks owe money to that the country (as a whole and not just the government) is going to be able to pay it all back. And in this context the sea change in mentality that Victor Mallet describes – assuming it is maintained – will be crucial. Those of us with rather longer memories – ones that stretch back to January for example – may wonder whether, once the immediate pressure is off, all that new found national resolve may not simply drift back into the mists from which it emerged, as has happened only too often in the past. Maybe the simplest and quickest way to help everyone feel comfortable that this was not going to happen would be to call in the IMF now, not becuase a bailout loan is needed yet, but as David Cameron is suggesting in the UK case, to carry out a “no holes barred” policy audit [9], so that everything which should be transparent actually is.

Who Really Likes Having A Dose Of Ebola Of course the problems which became all too apparent on Wednesday went well beyond Spain. Along with the CDS prices, bond spreads widened all across the European periphery – with Spanish, Greek, Portuguese, Italian, and Irish yields all widening in tandem. Yields on Greece’s two-year bonds briefly even hit an incredible 21%, following Standard & Poor’s downgrade of the country’s sovereign debt to junk status the day before. All of this and more finally forced the EU’s hand, and officials had to go rushing to the microphone to reassure investors that Greece would soon be able to access an aid package, with German Chancellor Angela Merkel going so far as to state that talks about providing aid should now be accelerated.

Well, Spain...

Then the numbers started to be filtered out, and evidently they were much larger than many had been expecting. According to press reports IMF chief Dominique Strauss-Kahn told German policymakers that Greece might need EUR120-130bn over three years, a number which the German press quickly calculated would mean that the German contribution might then go up to EUR25bn. Certainly, at the point of writing we still don’t know what the exact number will be – and it is not even sure they have decided yet – but the reality is that once the EUR120-130bn number is out there from an authoritative source, it will be hard not to hit it, if not exceed it. Then followed the announcement that IMF staff have reached an agreement with the Greek authorities on a 3-year program that will include draconian fiscal cuts (of the order of 10pc of GDP) and a series of structural measures aimed at driving nominal wages lower, reforming the pension system and building better institutions. Thus, the message this weekend to investors is: stop worrying about Greece for the next three years; you can continue to speculate in the secondary market, but the Greek government will be fine. And debt restructuring with the private sector now seems to be off the table for, at least for as long as the Greek government stick with the conditions – which will obviously be the aspect to watch

EURO ZONE ~ Spain carefully going forward. And even if there is an eventual default, the main counterparty will be other European governments (and the taxpayers who back them) and not private bondholders. On the other hand, Europe’s institutions have, at a stroke, opened themselves up to a large slice of what is known as “moral hazard”, since the implicit message is : what we are doing for Greece we’ll do for any other Euro-zone country, if needed. So from this moment on, we are all in up to our necks, if not beyond. This “historic moment” point-of-no-return dimension did not escaped the notice of Dominique StraussKahn either, since following his meeting with German politicians he was at pains to stress the potential contagion affect lack of backing Greece to the hilt would have had on the euro and the rest of Europe in the days to come. “I don’t want to hide behind a rosy picture. It’s not easy,” he said. All this “ can also have consequences far away. We have to face a difficult situation. We are confident we can fix it… But if we don’t fix it in Greece, it may have a lot of consequences On the other hand, Europe’s institutions have, at a stroke, opened on the EU.” themselves up to a large slice of what is known as “moral hazard”,

since the implicit message is : what we are doing for Greece we’ll do Highly respected US econfor any other Euro-zone country, if needed. So from this moment on, omist and Harvard University Professor Martin Feldwe are all in up to our necks, if not beyond. stein went even further, saying that in his opinion Greece will eventually default on its bonds and he feared other euro-area nations may follow, most probably Portugal. “Greece is going to default despite all the talk, despite the liquidity package,” he said. Portugal’s name is mentioned frequently these days, since although the government deficit and debt levels are lower in Portugal than in Greece and the Portuguese government has much more fiscal credibility than its Greek counterpart, when you add private sector debt to the public part the number is not far short of 300% of GDP, and in fact the underlying problems are very similar to those which are to be found in Greece. But it isn’t only in the South the the EU has to worry, since probems in the East continue to fester. The Hungarian forint had a fairly hard time of it over the past few days, and had a two-day intraday loss 3.6 percent on Tuesday and Wednesday, its biggest such fall since March last year. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. The drop followed revelations from Hungary’s incoming Prime Minister Viktor Orban that the country’s underlying fiscal deficit had in fact been rather higher than the previous government had acknowledged. So contagion may now be also moving Eastwards, meaning that EU institutions may now increasingly face a battle on two fronts, since the wobbling won’t simply stop with Hungary, there is Latvia, Bulgaria and Romania to also think about (just to name the first three that come to mind). As Angel Gurria, OECD Secretary General, said this week: “This is like Ebola. When you realise you have it you have to cut your leg off in order to survive…… it is contaminating all the spreads and distorting all the risk assessment measures. It is also threatening the stability of the entire financial system.”

EURO ZONE

A challenging What if...?

The thermo-nuclear option How politics can win the battle against the capital markets

................................................ European politicians are currently chased by the financial markets. No break, no time to breathe, the markets (or banks, or hedge funds, or some monster speculators, who knows these days) have lost confidence in the euro, the euro zone and Europe, they flee in droves, they short the Euro, they throw the PIGS bonds out of their portfolios and into the open arms of the Eurozone States and the European Central Bank (ECB). Not even the so-called “nuclear option” has impressed those markets - the purchase of government bonds by the ECB. There`s no end in sight for this crisis of trust and European public finances.

by Detlef Gürtler

Or is it? In this article I describe a policy option, that could give the initiative back to the states and bring the capital markets in defense mode. This option would put the financial system as we know it at risk - that’s why I call it the “thermo-nuclear option.” But if the alternative is either to destroy the European Union or twenty European banks, the death of these banks would be preferable. And such as the financial system has behaved in the recent years, it could indeed be useful to construct a new one. It’s a typical European weekend in the spring of 2010, the government and central bank chiefs are in hectic discussions, looking for an answer to the latest wave of distrust of the markets against the euro in particular and Europe in general. But instead of bundling the next multi-billion euro rescue package, this weekend’s decision has only one sentence: The European leaders clarify their decision of May 16 by emphasizing that the Eurozone’s rescue money must not be used for the rescue of banks. “A country that wants to recapitalize its banks, can do that - but with its own money,” says Angela Merkel at the final press conference. Spanish Prime Minister Jose Luis Zapatero couldn’t participate at that press conference. He went off for a meeting with Miguel Ángel Fernández Ordóñez, the President of the Spanish central bank, Banco de España. Within hours after the EU decision Fernández orders that until further notice all the Spanish bancos and cajas shall stay closed. Without state guarantees a restructuring of the Spanish banking system becomes inevitable, and instead of letting bank after bank fall like dominoes, Spains central banker wants to find a sustainable solution for the whole sector. Of course the foreign creditors are invited to participate in the search for such a solution. The entire volume of either new capital or write-offs on outstanding loans might reach 200-500 billion euros. Spain is not Greece. Greece was indeed a problem of public debt: the Greek governments mounted such a colossal public debt that they couldn’t find a way out on their own. That way was paved by EU governments and the International Monetary Fund (IMF). But Spain is a problem of private debt. Spain’s citizens and enterprises are indebted with approximately 2.2 trillion Euros, about half of which is financed by foreign investors. The Spanish government, however, is indebted with moderate 55 percent

EAST OF THE DANUBE of national GDP (at the end of 2009): Germany, for example, is in a significantly worse position with a public debt ratio of 75 percent of GDP. It is written nowhere that the Spanish government is accountable for its citizens debts. If there is someone who has lent them money for the construction or purchase of real estate, and if that money won’t be paid back, then this someone should take the responsibility, and the losses. Of course that’s in the first place the job of the Spanish banks. But in the second place, it’s the job of all those national and international investors who bought their shares, their bonds, and their mortgage backed securities. There are hundreds of thousands of such bad loans, even millions. The gaping holes that open up in the balance sheets of the Spanish banks can no longer be filled by themselves. Someone must step in. Until now, the markets seem to believe that this someone will be the Spanish state: just as Germany saved IKB and Hypo Real Estate, following this calculation Spain would save Banco Popular and Caja Madrid. But Spain can raise the necessary money for that only if the Eurozone guarantees for it. And that’s exactly what the Eurozone should not do. Leave it up to the markets: Let the countries decide about the bailout for countries - and let the banks decide about the bailout for banks. Investment in Spanish banks and companies is widely diversified in the capital market, both banks and insurance companies and investment funds from all over the world would be affected. Yes, such a move could destroy the global financial system. Not because two trillion euros of debt could not be restructured, but rather because the discontinuation of explicit government guarantees could lead to bank meltdowns in other countries at the same time. But the opportunity to build a new financial system from the scratch should sound attractive at least to the decision-makers in European governments. For those in the financial markets, the risk would certainly be bigger than for the politicians - and the chance to benefit from a system restart significantly smaller. Even for Spain that “thermonuclear option” would offer a chance: a lot of new real estate investors. The over-indebtedness of Spanish households and businesses was caused by the real estate bubble inflated after the introduction of the euro. When the bubble burst in 2007, it left a few hundred billion euros unserviceable debts and one to two million empty flats - especially in the tourist areas along the Mediterranean coast. Meanwhile, a large part of these apartments have found their way to the balance sheets of Spanish banks. So they have some assets to offer when negotiating about a debt restructuring: For every million Euros a creditor forgives he might get three apartments at the Costa del Sol. Or four, or five, or ten. At the end, the PIMCO’s, Swiss Re’s and WestLB’s own tens of thousands of brand new Spanish homes, for which they should come up with some productive use. Surely they will do better with that than the Spanish State would do.

EURO ZONE ~ Spain

Spain At The Crossroads ........................................ This is an important, possibly decisive moment in the country’s history. By Edward Hugh

Spain stands at the crossroads. This is an important, possibly decisive moment in the country’s history. On one side lies the possibility of grasping the nettle, and using the present crisis to make changes which should have been made years ago, in the process transforming the economy into a global competitiveness leader. This is the Finish path. In the early 1990s, following an uncontrolled credit boom Finland underwent a deep depression as its GDP dropped by around 14% and unemployment rose dramatically from 3 to almost 20%. Initially the Finish government refused to recognise the severity of the situation, and the economy failed to recover. Then they took the “bull by the horns”, carried out a series of deep structural reforms and as a result the country is now widely recognised as a model of flexibility and good practice. The other path is to do very little, live in hope, and expect the worst. This is the road to ruin and decay. The Argentine path.

Argentina or Finland?

According to the most recent report from the IMF, Spain’s economy needs far-reaching and comprehensive reforms. The Fund stress that the challenges facing Spain are severe: a dysfunctional labor market, a deflating property bubble, a large fiscal deficit, heavy private sector and external indebtedness, anemic productivity growth, weak competitiveness, and a banking sector in need of significant restructuring. They also note with approval the recent

EURO ZONE ~ Spain

fiscal adjustment measures introduced by the Spanish government – these are vital to restore investor confidence - but point out that these alone will do little to return the Spanish economy to growth over the next year or so. According to the IMF government policy should focus on fostering the smooth rebalancing of the economy, which means taking urgent and decisive action on: • making the labor market more flexible to promote employment and enable reallocation across sectors; • fiscal consolidation to put public finances on a sustainable footing; and • banking sector consolidation and reform to cement the soundness and efficiency of the system. When it comes to labour market reform the Fund focuses on the need to reduce the duality (between fragility and security) which exists in the labour When it comes to labour market reform the Fund focuses on the market by encouragneed to reduce the duality (between fragility and security) which ing permanent hiring via exists in the labour market by encouraging permanent hiring via lowering severance paylowering severance payments. What is not clear at this point is ments. What is not clear at this point is whether the whether the change will only apply to new contracts, or whether change will only apply to existing contracts will be modified. new contracts, or whether existing contracts will be modified. This is obviously a key topic, as the biggest potential short term benefit from a reform which allowed employers to release older workers would be to facilitate the trimming down of workforces as part of corporate restructuring. This has a political cost however, since it would inevitably increase the short term unemployment rate. Making it cheaper to fire people in the longer term may well encourage

EURO ZONE ~ Spain employers to move workers over to more permanent contracts, but it will hardly generate much in the way of new employment in the present environment. Another key proposal involves boosting wage flexibility via decentralizing wage bargaining and, in particular, the elimination of price indexation. But unless such bargaining is to be oriented towards negotiating wages downwards, again there would be little in the way of short term gains from this. The IMF speaks in terms of benign inflation being a mechanism to restore competitiveness, but this will hardly be sufficient unless the key German economy has significant inflation at the same time, hence the relevance of Olivier Blanchard’s 4% ECB inflation target proposal, although it is hard to see either the ECB or the German public at large ever agreeing to this. Again, timing is important here. Spain’s problems are pressing, and as the IMF suggest in an ideal world Spain’s social partners would serve up results quickly, given the severe problem of unemployment. The IMF report notes that agreement was expected by the end of May, yet at the time of writing (the end of the first week in June) there is still no agreement, and details about what the government intends to do remain scarce.

A Banking Sector With Problems Finding Funding As the Fund notes, restructuring of Spain’s Cajas is an urgent priority, but as they point out the situation is complicated by a number of factors. In the first place a considerable part of the repossessed real assets owned by the Spanish banking system is land, and this is particularly difficult to value, and may have a much lower value than many anticipate now that the boom is well and truly over. Progress, under the aegis of the Fund for Orderly Bank Restructuring (FROB), has, however, been far too slow, more for political than economic reasons, since the cajas are often under the influence of local administrations. Secondly, with so much pressure on the ability of Spain’s government to finance itself, it isn’t even clear at this point how the markets will react to the instruments needed to fund the FROB itself. Further, the IMF assesment of the Spanish banking system contained in the Global Financial Stability Report (prepared under the oversight of former Bank of Spain official José Viñals) contained some rather controversial analysis. The report, for example, says that “Under our (the IMF) adverse case scenario, three years of earnings are projected to cover future losses for the commercial banking sector, leaving the capital base intact, but the savings banking sector is projected to have a net drain on capital.” This argument unfortunately contains a number of flaws.

EURO ZONE ~ Spain In the first place Non Performing Loans (NPLs) are not an average problem, they are a specific one, i.e. there are good banks and bad banks. Speaking of the banking sector as a whole, doesn’t make much sense. There will be banks that are fine and banks that will fail. The really interesting question is, how many banks will fail? When that happens, there are stresses in the interbank market even for good banks. During the US sub-prime aftermath over 90% of banks in the US didn’t fail, but the US had a systemic banking crisis. Secondly, the IMF statement doesn’t say where the earnings are going to come from. Most probably the Bank of Spain is presuming the presence of a steep yield curve and high net interest margins (NIM). However, NIMs lag euribor rates, and they will come down, not up. When rates come down quickly, deposit rates are cut quickly, and loan rates slowly, which is why cutting rates boosts banks immediately. However, now many Spanish loans have been resetting to lower rates tied to Euribor. In a situation where European rates rise, NIMs will be hurt. Also, Spanish banks rely on wholesale funding, which is why as the money markets have fgradually closede to them the banks have initiated a deposit war. Further, the fund admits that their “econometric approach (to assessing losses) does not capture an additional risk factor related to private leverage, which has dramatically increased over the 10 years of credit boom. Another weakness of the econometric approach comes from the use of historical data which predicts a higher peak for NPLs at commercial banks, based on the historical experience and slowing NPLs at savings banks in 2009.” This pretty much gives the game away unfortunately, since following the lead of the Bank of Spain they seem to be assuming that rising leverage isn’t a problem, or put another was that Spain’s For their adverse scenario, the IMF says “Under these circumstances, problems are linear, and Non Performing Loans are forecasted to peak in 2011 at 7.8 percent that this is just like every and 7.1 percent for commercial and savings banks, respectively. other recession, which it LGDs for nonperforming loans are assumed at 45 percent for both obviously isn’t.

commercial and savings banks, respectively, and LGDs for repos-

Essentially they assume sessed properties are at 55 percent and 60 percent, respectively. that NPLs have already peaked and will now go down, although there seems little justification for such an assumption given that NPLs typically lag business cycles by a few quarters, and making the heroic (and hardly justified) assumption Spain is out of the recession and will start growing, NPLs simply could not have peaked yet. Just look, for example, at

EURO ZONE ~ Spain the level of unemployment. Also the Fund seem to pretty much buy the argument that banks are good managers of real estate and prices will go up. “Over the last two years, given the ailing state of the real estate and the construction sectors, Spanish banks have increased the use of debt-for-property swaps to manage their credit portfolios efficiently, trying to maximize asset value recovery. This practice helps banks in managing of their credit risk portfolios and minimizes losses, provided that property prices stabilize in the medium term and banks can sell those assets at their book value.” For their adverse scenario, they write, “Under these circumstances, NPLs are forecasted to peak in 2011 at 7.8 percent and 7.1 percent for commercial and savings banks, respectively. LGDs for nonperforming loans are assumed at 45 percent for both commercial and savings banks, respectively, and LGDs for repossessed properties are at 55 percent and 60 percent, respectively.” So under a double dip recession, their NPL ratio is still below the 1992-94 banking crisis, surely they cannot be serious when they say this.

But Where Will The Growth Come From? Returning now to the main argument, as the IMF stress, while the fiscal adjustment urgently needs to be complemented with growth-enhancing structural reforms, like overhauling the labor market and introducing a bold pension reform, these measures, necessary as they are for the stability of the Spanish economy in the longer term, will not act quickly enough to change the dynamic of the debt in the shorter run. As Unicredit analyst Philip Gisdakis said in a recent report “The bad news for investors is that due to the reforms, Spain’s economic indicators will turn even more negative before they start to improve. Harsh austerity measures and a reform of the banking system in the midst of a deflating property bubble is definitely not a growth stimulus package.” The fiscal measures so far adopted involve a reduction in government spending over 2 years of something like 5% of GDP. To this must be added the measures contained in the Law for a Sustainable Economy (Ley de Economia Sostenible) for reducing the time which Local Authorities and Autonomous Communities take to pay their short term debt. According to my calculations this will mean an additional adjustment of something like 3% of GDP over the next three years, or 1% a year. As a result of the severity of this adjustment, the Spanish economy will not return to growth in 2011. Here the Finnish case was different, since Finland had its own currency, and was thus able to restore competitiveness through a substantial devaluation, a devaluation which then required the creation of a bad bank to relieve lenders of toxic assets produced by the rapid rise in non perforing foreign currency

EURO ZONE ~ Spain loans. Whatever growth Spain’s industry manages at the moment is likely to be tepid. According to the latest monthly report from Markit Economics Spain’s industrial sector continued to enjoy a period of modest growth in May, although new business increased at the slowest pace since the period of expansion, and the rate of growth in new export business also delined. More significantly, the only positive signs were linked to increases in demand from the US and emerging markets. What does this mean? It means that the recent growth in demand for Spanish exports is largely the result of the decline in the value of the euro, and that Spain, despite urgently needing to improve its export performance, is not succeeding in doing so in other member countries of the Euro Group, even though some of these economies have started to recover far more rapidly than Spain itself. Now why are exports so important for the Spanish economy at this point? Well basically because the strong domestic demand with drove the economy over the last decade has now moved into reverse gear as families and companies try to reduce the level of their debt. Spain’s household sector has a debt level which is well above the euro area average: household debt equates to 106% of household income, compared with 95% in the euro zone. Net debt (debt minus household deposits) is 10% of household income in Spain, whereas the euro zone household sector is a net creditor to the tune of 9%. Household sector deleveraging started in mid 2008, and is set to continue, and this will inevitably weigh on growth. Meanwhile the saving ratio of Spanish households has also increased significantly - to almost 19%, well above the level of its peers. And this saving ratio is likely to remain high for some time, given high unemployment, the decline in household wealth, and financial constraints related to debt-servicing. Thus correcting the excess indebtedness will almost certainly prevent the above-trend bounce-back in growth typically seen in post-recession recoveries. The situation in Spain’s corporate sector is not substantially different, since both gross and net debt levels are significantly higher than the eurozone average, and while deleveraging appears to be progressing more slowly in Spain’s corporate sector compared with its household sector, it is hard to see investment to meet the needs of domestic demand driving a recovery. In this situation the only two sectors of the economy where growth could be expected would be those of government consumption and trade. But with the state now implementing a strong fiscal correction public sector demand is already in decline, which leaves only exports to pull the Spanish economy forward. Meanwhile Spain continues to run a trade deficit, which means the deterioration in the total net external debt burden has not been halted. Fitch recently estimated that Spain would need to achieve a primary current account surplus of 1.4% of GDP simply to stabilise the net international liability position. And we are a long way from achieveing that, since Spain recorded a primary current account deficit of 2.6% of GDP at end 2009. And this is simply to halt the decline. Reducing the debt will mean achieving much larger surpluses, and if this is not to involve a very sharp fall in living standards, then the burden

EURO ZONE ~ Spain of achieving the surplus will need to fall on export growth and not simply on import reduction. But it is here that the competitiveness problem which faces Spanish industry raises its ugly head, since although the share of Spain’s exports that go outside the eurozone is far from insignificant (over 40%),

such exports only constitute less than 10% of total Spanish GDP. So leveraging the whole economy on the back of growth in such a small proportion of total output is going to be very difficult indeed, a no decir imposible. On the other hand, some Northern European economies have large extra–eurozone export shares. Germany - for example - has 23% of GDP, and the Netherlands 26%. The potential external demand gains from the large depreciation of the euro are large, raising the danger that the fall in the euro becomes yet one more factor widenening the already serious intra-eurozone differences in economic growth performance, and in the process increasing the political tensions between North and South. So what is the solution? Well the important challenge for countries like Spain, Portugal and Greece is to dramatically raise their competitiveness with regard to other eurozone economies in order to both reduce import penetration (and create jobs at home) and to take advantage of the stronger growth generated in those economies which can benefit substantially from the euro fall. And this is where the proposal for a substantial reduction in prices and wages (of around 20%) becomes important. Structural reforms and productivity improvements can evidently help, but they will not act quickly or dramatically enough to restore growth to the sickly Spanish economy. What we need is a “golpe de efecto”. How would this be done, many ask? Well the difficulties of so doing should not be underestimated, but neither should the problems which will inevitably arrive if we fail to act. And there are precedents: Germany between 2002 and 2005 implemented a major competitiveness improvement programme which

EURO ZONE ~ Spain involved increasing hours worked for the same salary - and as the Germans discovered, in general workers found it easier to put in the extra hours than to accept a direct pay cut. At the same time making salary agreements sensitive to downward (as well as upward) movements in prices can also help. But more than anything else some broad national consensus (involving both employers and unions) needs to be achieved (some have even spoken of the need for some kind of Pactos de la Moncloa II) - invoking the same spirit which saw Spain pass through a largely bloodless transition from dictatorship to democracy. The challenge is formidible, but no more formidible than the costs of failing to act. The present situation is unsustainable, as can be seen with every passing day as the spread on both public and private debt continues to rise. Something, somewhere is bound to give. Really there are now only two possibilities: either the countries of the South take substantial measures to restore competitiveness (and not simply reduce the fiscal deficit) or Germany will be forced to return to the Mark, with all the risks that this would imply for the future of European political integration. To many this kind of radical price and wage adjustment proposal is simply unrealistic. But at this point there are few remaining alternatives. Spain is gradually replacing Greece as the focus of global investor concern, and while people in Spain may have little appetite for such drastic changes, they should never forget that across in Germany, where people are now being asked to authorise funding for substantial loans to be used on Europeâ&#x20AC;&#x2122;s periphery, support for proposals that the country return to the Deutsche Mark is growing by the day. As the IMF point out, any comprehensive strategy to move the Spansih train along the track which leads to the Finland station requires broad political and social support, while time is of the essence.

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Conservative Landslide in Hungary

The Comeback of a Political Survivor .......................................................... The outright victory of Viktor Orbán’s FIDESZ party in the second round of Hungary’s parliamentary elections on on 25 April opened a new stage in the unfolding of Hungary’s entangled political and economic crises – crises that have been in process since the summer of 2006. In fact FIDESZ was elected with a two thirds majority, which is enough to modify major laws and even the constitution. Most discussion of the election outside Hungary By Mark Pittaway focussed on the 16.67 percent won by the neo-fascist Jobbik party, with its explicit racist rhetoric towards Hungary’s Roma, its open anti-Semitism and its uniformed paramilitary wing, the Hungarian Guard. Within the country attention focussed, especially among FIDESZ’s defeated left-liberal opponents, on the probability that FIDESZ would use its new found power and influence to purge the public sector and the media of its opponents, waging an intensified version of the “culture war” it conducted against the liberal left when it was last in power between 1998 and 2002. Viktor Orbán himself ranks among Europe’s most persistent political survivors. In 2002 he was narrowly defeated by a coalition of Socialists and the liberal Alliance of Free Democrats in an election he was widely expected to win that took place in a benign economic climate. This defeat was largely self-inflictOrban: the widest majority ever in postcommunist Hungary ed and a product of FIDESZ’s authoritarian and confrontational policies towards its opponents. A further, and larger defeat in 2006 seemed to confirm the outcome of 2002 – that Orbán’s divisive style and widespread suspicion of his authoritarianism and use of right-wing populism would keep FIDESZ out of power for a long period. In the light of this, Orbán’s political survival and return to power are worthy of explanation. In the

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morrow of his defeat in 2002, Orbán began to transform FIDESZ from a traditional political party into an alliance of disparate movements originally integrating elements on the far right into a broad political coalition. A politics of using the deep-seated left-right polarization within Hungary to integrate the far right into his coalition was combined with a reach for the political centre by seeking to present FIDESZ as a party that stood for an expansion of welfare protection for the population – a kind of social democracy in national colours. Re-launched as FIDESZ-the Hungarian Civic Alliance in 2004, the party promised an expanded welfare state and lower taxes, while it began using Welcome back, Viktor the provision in the Hungarian constitution to initiate referenda as a campaigning strategy. Between 2004 and 2006 this strategy failed, yet it has been used to considerable effect since 2006 – though this effect has been less the result of trust in Orbán than a consequence of the political failures of his opponents and the unwinding of Hungary’s post-socialist economic model. After the deep recession that followed the collapse of state socialism during the early 1990s, Hungary produced growth of 4-5% per annum during the latter half of the decade as a consequence of favourable economic circumstances, the apparent stabilization of the country’s external debt as a consequence of receipts from the privatization process, and an influx of FDI, largely of German and Austrian origin, in the expectation of speedy Hungarian membership of the European Union. Growth peaked in 2000 and after this date the circumstances that underpinned it began to unwind. Hungary’s competitiveness vis-a-vis its German and Austrian neighbours declined progressively, exacerbated by the strength of the Forint, while the EU’s decision in 2000 to support a large eastern enlargement, rather than one in which a select number of countries in Central Europe would gain EU membership intensified competition for FDI. While growth averaged 3-4% per annum until 2006, this was only maintained by running larger fiscal deficits and as a consequence of the demand created by increased consumer indebtedness fuelled by the de-regulation of financial markets that occurred in the wake of the consolidation of the banking sector and with EU membership. As predominantly Austrian-owned entrants into the personal lending markets sought to increase market share they used the strong Forint, and high

EAST OF THE DANUBE Forint interest rates to offer loans to households denominated in foreign currency, predominantly in Swiss Francs, but also in Euros, and even in Japanese Yen. In 2004 the Socialist-Free Democrat government, believing they faced defeat in subsequent elections, ditched Prime Minister, Péter Medgyessy, and replaced him with Ferenc Gyurcsány. Faced with a large opinion poll deficit and attacks from FIDESZ that called for an expansion of welfare spending, Gyurcsány sought to gain re-election through maintaining large public deficits. As a consequence of pre-election spending both the European Union, and international credit rating agencies became increasingly nervous at Budapest’s poor control over public spending, and its attempts to move some public expenditure – notably on motorway construction Socialist Gyurcsány “We lied morning, noon, and night” projects – off the balance sheet. The patience of financial markets was stretched up to the elections in April 2006, which Gyurcsány won, aided by a cut in the rate of VAT on luxury goods from 25% to 20%, and unfunded promises of tax reduction over the coming parliamentary term. Austerity followed the election as taxes were hiked, spending was cut, while co-payments in health and higher education were introduced. The government became severely unpopular by the beginning of summer, a situation compounded by a series of communication errors that culminated in the leaking to the press of a recording of a speech by Gyurcsány in which he admitted “we lied morning, noon, and night” to win the elections in September, and several months of disturbances on Hungary’s streets.

Ultra-nationalist Gabor Vona also celebrates

The austerity programme effectively removed demand from the economy, while the strong Forint policy was maintained by the central bank, and foreign currency lending continued apace. The economy stagnated, entering its first recession since 1993 in early 2007. Enormous discontent with austerity measures focussed on the figure of Gyurcsány, who many believed had shamelessly lied to win the election. Street demonstrations

EAST OF THE DANUBE radicalized sections of right-wing opinion, which laid the basis for the future rise of Jobbik, and FIDESZ attacked directly the austerity programme with a series of several citizen-initiated referenda, three of which – on two sets of co-payment in health, and one in higher education- made it onto the ballot. When these referenda succeeded in March 2008 by large margins, they weakened Gyurcsány fatally, but also strengthened FIDESZ’s credibility with a Hungarian electorate tired of market-based reform and frustrated at cuts in living standards as a party that offered social democracy in national colours. Thus, even before Hungary was forced to call in the IMF in October 2008 at the height of the global financial crisis the stage was already set for FIDESZ’s return. Events since – the fall of Gyurcsány in March 2009 and his replacement with Gordon Bajnai along with continued IMF-sponsored austerity; the electoral collapse of the Socialist Party; the rise of an explicitly neo-fascist party with mass support, especially in ex-Socialist voting industrial areas; and the victory of FIDESZ stems from the intensification of the impact of factors already visible in 2002. The FIDESZ led list with its 52.73% of the votes has become the first party to win an absolute majority of the popular vote since 1990. Its success reflects the considerable support among large sections of Hungarian society for a government that offers social democracy in national colours, and a desire for a period of respite from continued falls in living standards. This is revealed by opinion poll data and the broad geographical distribution of its support in the first round, where it was able to lead its opponents even in many of the formerly Socialist-voting strongholds in the working-class eastern suburbs of Budapest. Its electoral success was aided by its failure to offer any kind of concrete programme to the electorate, which allowed potential supporters to project their desires onto the party. Yet this strength is now clearly a weakness moving forward. The latest figures suggest that Hungary’s GDP declined by 6.3 percent in 2009, and will continue to decline at a slower pace in 2010 – though the precise extent is uncertain due to the country’s dependence on exports to the Eurozone. Independent experts believe that Hungary will have severe difficulties in keeping its budget deficit below 4% in 2010 without urgent remedial action to raise revenues and cut spending. Furthermore, these figures do not include the deficits and the lending undertaken by local authorities, many of which are on the edge of bankruptcy, as are Hungarian State Railways and the Budapest Public Transportation Company. Consolidating these entities will place further pressure on the budget. There remain question marks over the long-term financial health of the Hungarian financial sector. At the same time, given the high value of the Forint against the Euro, the consequent persistence of the problem of Hungarian competitiveness, and the continuing burden of financing debts in both the public and household sectors, Hungary’s economy seems to be condemned to either stagnation or sluggish growth for the foreseeable future. FIDESZ’s approach to these problems is almost completely unknown. It is difficult, however, to imagine that the measures they will have to undertake to deal with this situation, in all probability underpinned by an IMF loan, will be anything other than extremely painful.

EAST OF THE DANUBE Hungarian households are under severe pressure from declining real incomes, unemployment and the fear of unemployment, and the burden of servicing loans denominated in foreign currency. Furthermore, Hungary is now entering its fifth year of austerity and consequently the climate in the country is very tense, as the patience of the population with this situation is thin. Orbán has never been a universally popular leader and his divisive style seems to make him deeply unsuited to leading Hungary through the crisis. Furthermore, he will face considerable opposition both from his left, and from a militant, insurgent neo-fascist right. At the same time in a clientelist political system he will face enormous pressure to reward his supporters, and failure to do will meet with negative consequences. For these reasons, despite the size of his victory, it is difficult to see his position as being very secure. Hungary’s road out of the crisis will be, at the very best, a bumpy one.

Hell Knows No Fury Like A Financial Market Being Told You Are About To Become The Next Greece Following several days of political chaos, and indeed uncertainty in the financial markets surrounding the suggestion that Hungary was set to become the new Greece (with the suggestion, surprisingly, coming not from bank analysts, but from leading Hungarian politicians themselves) the government has now issued a new measures it is going to take to bring the country’s fiscal deficit problem under control. Hungary’s new prime After sweeping an April election with a two-thirds majority, the inminister Viktor Orban coming FIDESZ government unveiled a program which departed has said his governdramatically from that of the previous caretaker Socialist cabinet that ment will cut public had been following the outline of an IMF Programme introduced after wages, overhaul the the country narrowly avoided economic meltdown in 2008. tax system and ban mortgage lending in foreign currencies in a desperate attempt to reassure nervous investors he can contain the country’s budget deficit. After sweeping an April election with a two-thirds majority, the incoming FIDESZ government unveiled a program which departed dramatically from that of the previous caretaker Socialist cabinet that had been following the outline of an IMF Programme introduced after the country narrowly avoided economic meltdown in 2008. Initially the party had pledged to cut taxes and create jobs in an attempt to stimulate the growth the country evidently badly needs to tackle its heavy debt burden, although such moves would obviously threaten targets agreed under the country’s 20 billion euro European Union/International Monetary Fund bailout. Struggling to win back market confidence after Fidesz officials rattled investors by warning of a Greekstyle debt crisis last week, Orban has now committed his government to introducing a flat 16 percent income tax. He also said his government would also raise taxes on companies and ban mortgage loans in foreign currencies.

Struggling to win back market confidence after Fidesz officials rattled investors by warning of a Greek-style debt crisis last week, Orban has now committed his government to introducing a flat 16 percent income tax. He also said his government would also raise taxes on companies and ban mortgage loans in foreign currencies. 68

EAST OF THE DANUBE The high preponderance of forex loans (largely CHF, over 85% of total mortgages) has been a massive aggravating factor in Hungary’s ability to conduct an effective monetary policy in a context of high inflation and low growth. Many internal observers raise the following points about the difficulties of converting existing loans. 1) the interest differential between HUF loans and CHF ones is very large, so who will willingly convert? 2) assuming there was a large uptake on the conversion who would take on the conversion risk? 3) the Hungarian banking system on lends external borrowing as foreign currency domestic loans to Hungarian nationals. Since local saving is inadequate to fund local borrowing, if the banking system is forced to lend exclusively in local currency how do they borrow? In foreign currency? How do they convert? With swaps? And how do they manage the mark-to-market risk of HUF rate fluctuations on swaps?

In the last chance saloon Global Spectator’s Hungary correspondent Mark Pittaway writes:

The abovementioned problems are very real ones, and there is no simple way around them without some major restructuring of the banks. Let’s look at the viability of one proposed alternative. 1) keep the HUF/EUR exchange rate as close to its present level as possible, and 2) solve the problems through increased growth through exports. These two objectives are in conflict, and without reducing the value of the country’s currency (HUF) substantially (to what level, who knows, but possibly HUF350 to the Euro would be appropriate), then the conditions for the sufficient degree of growth to pay down debt through exports don’t exist. And if HUF reaches this level (and with CHF even stronger that the Euro) then one is going to see a severe problem of foreclosures - and here we are not just talking of homes, but a lot of consumer loans, and loans to small businesses are FX ones. This then is going to have a boomerang effect on the banks, and on the general supply of credit anyway. So this is no real solution. The Hungarian authorities ought to take the pain now through conversion, and give themselves the chance of some growth through an orderly devaluation. In practice, Hungary is attempt to walk a tightrope, and will need a lot of luck, and dynamic growth in the Eurozone to pull off the trick the government seems to be going for. If they are not lucky, then the markets will call time on this eventually - and HUF will fall. Immediately after the election, economy minister György Matolcsy floated the idea of forced conversion of CHF/EUR loans. This is clearly a basic condition of any policy that is sensible in Hungary, because any

EAST OF THE DANUBE such policy will produce a fall in HUF. The issue of course is who pays - and some of the paying will have to be done by the banks. The banks, of course, don’t want to pay anything, and therefore the new government was firstly placed on a direct collision course with the financial sector. And, of course, with the only Hungarian owned bank, OTP. Basically the Hungarian government will need to start thinking about a restructuring of the banking sector; almost certainly involving the nationalization of OTP, if either forced reconversion becomes necessary, or if there is a substantial increase in defaults in FX loans. If they want to try to preserve most of the financial sector in its present form, then they will have to try and maintain a HUF/ EUR exchange rate that The Hungarian authorities ought to take the pain now through conis low enough to keep version, and give themselves the chance of some growth through an the export sector alive, orderly devaluation. but high enough to avoid the critical point In practice, Hungary is attempt to walk a tightrope, and will need a lot at which defaults become a major problem. of luck, and dynamic growth in the Eurozone to pull off the trick the And the only way to government seems to be going for. If they are not lucky, then the mardo this is to keep tight kets will call time on this eventually - and HUF will fall. control of the budget deficit, and hope that the German/Austrian economies are sufficiently dynamic to rescue Hungary from recession through exports. This is an impossible balancing act - but it was the balancing act that the previous Bajnai administration was trying, and it is the one, I think, that will seem like the line of least resistance to the financial elite. The signs are that Matolcsy decided after floating forced conversion that he could not politically (1) enforce HUF loan conversion on the banks, and (2) re-structure the financial sector as the consequences became clear, he could not (3) countenance a devaluation of HUF. Therefore he has gone for what he believes to be the line of least resistance. It is more than likely that the HUF is going to fall substantially anyway, and Hungary’s banking sector will not survive in its current form, so they may as well do it in an orderly fashion and control the process. Prime Minister Orban’s position seems to be more political than economic. He needs tax cuts and some relief in living standards to consolidate FIDESZ control over local government in the forthcoming municipal elections; thus he needs a higher deficit this year. It seems though that Orban has little idea of the economic constraints that Hungary is under. Evidently the FIDESZ party is deeply divided at this point. However, in one key sense, the Orban side in this dispute is onto something that others have not grasped. That is that society is not going to tolerate any further period of restriction without quite radical political consequences. A lack of support and legitimacy destroyed the reform that the Gyurcsany government undertook, and Orban’s fate will be the same. Indeed the EU, the IMF, and the Hungarian government are risking the outright collapse of the political system - the message of the elections was that those parties who most unambiguously advocated the sorts of economic policies the EU advocate were wiped off the political map, and taking Jobbik and LMP (Green Liberals, created in 2008, 7.48% of the popular vote) together it is clear that one in four votes went to parties that (1) didn’t exist before in any real sense, and (2) campaigned on programmes that were explicitly opposed to the principles of a market economy. Democratic politics in Hungary is now in the last chance saloon, and the political centre desperately needs to shore up its legitimacy and credibility with the population - unfortunately the only bargain that will be sustainable and acceptable on the popular side are increased living standards in exchange for structural reform. But, unless they are prepared to redistribute wealth substantially from the rich, I don’t see how they can build this base among the population.

LATIN AMERICAN WIRE

Chile Back to International Bond Markets ........................................................................... By Beng Mortenson

The Chilean President Sebastián Piñera is preparing the country’s return to the international debt markets. The Chilean government will have to finance about 8.4 billion dollars of the 30 billion that it is likely to cost to rebuild the country after the 8.8 force earthquake that struck it in February, the rest of the cost is expected to be borne by insurance companies. Chile has been away from the international capital market since 2004. Unlike other Latin American countries Chile had enough domestic savings, and foreign loans were not needed. According to Mr. Piñera, reconstruction costs will be funded from a combination of fiscal austerity, use of the copper fund, debt, and the sale of public sector assets. Tax increases are not ruled out – and increased taxes on companies and mining royalties are expected. According to Finance Minister, Felipe Larraín, Chile plans to raise $1.5 billion on international capital markets by selling two 10-year bonds. The issuance, includIt will cost 30 Bn to rebuild the country after the earthquake ing an unprecedented $500 million of peso-denominated bonds, marks a clear change in the country’s strategy to access capital markets. The government is already working with the banks on the issue, and sales are expected to be quite quick. Expectations that Chile would tap its 11 billion dollar sovereign wealth fund to pay for the reconstruction efforts have been affecting the peso of late due to the expected dollar inflows. Chile’s peso has climbed 12.3 percent against the dollar in the past year, and is the third-best performing major Latin American currency after the Brazilian real and Colombian peso. Larrain also stressed the historic significance of the move: “This will be the first issuance of a peso global bond in Chile’s history, and it is part of an agenda towards the internationalization of the Chilean peso,” he said. “This is not just a one-time issue. It is part of a medium-term strategy to feed relevant points in the yield curve. We will be coming to the markets. We make no commitment we will come every year, but we will come to the markets to provide liquidity.”

LATIN AMERICAN WIRE Larrain, however, made plain that the government intended to be cautious when tapping the fund to avoid strengthening the currency and so hurting the country’s productive sector. “We don’t want to deplete the fund. Last year the fund suffered a drop of $9 billion (to fight the global financial crisis). At that pace, we will not have a fund in two years,” he said before a presentation to the Council of the Americas. The minister said the government hasn’t decided how much of its sovereign fund it will use but forecast Chile’s financial needs for this year will be around $6 billion, $1.5 billion of which will be financed by the issuance of the two bonds. The other $4.5 billion will come partly from the sovereign wealth fund but “mainly” from domestic debt issuance, he said. The issuance of bonds, in addition to financial reconstruction, forms part of a government initiative to issue them regularly in the international market thus providing a reference for Chilean companies that want to issue debt. And indeed the Chilean holding company Corp Group Interhold, which controls local bank Corpbank, issued $130 million in international bonds at the end of April. Standard and Poor’s rated the bond issue BB, while Fitch Ratings gave it a BBB- rating. Mr. Larraín anticipated that market prices would reflect the lower risk premium Chile has when compared with other Latin American countries.

Minister Larrain: lower risk than others

Moody’s Investors Service lifted the country’s credit- rating last year to A1, the fifth-highest rating, citing the copper savings. Standard & Poor’s grades Chile’s debt A+, in line with Moody’s. Fitch Ratings ranks it one level lower at A. These levels are, of course, well above those boasted by a Eurozone member like Greece, and well above the ranking of many of the EU’s East Europe members. Although the quake damage is estimated to total some 17% of GDP, Chile’s total debt is less than 1% of GDP, a factord which will certainly be important in getting a positive response to the issue. There has recently been a strong demand for emerging-market debt at a time when market participants are looking for better returns when interest rates in developed countries are at historic lows (see “Rising Like A Ton Of BRICs [1]” in this issue). Partly helped by the crisis in the Southern Europe, some countries which were previously considered to be high-risk are now able to place debt with lower yields. In April Russia and Brazil successfully sold government bonds with historically low yields. The Chilean economy is expected to grow by 6% this year and over the next decade it could reach a GDP per capita of $ 20,000, not that much lower than a country like Portugal. According to Mr. Larrain, the earthquake has not had any noticeable inflationary effect, and the rate of inflation should remain below 4%, probably approaching the 3% central bank target in 2011. Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net URL to article: http://www.globalspectator.net/?p=174 URLs in this text: [1] Rising Like A Ton Of BRICs: http://www.globalspectator.net/?p=140

LATIN AMERICAN WIRE

Drug cartels lose weight in Colombia ........................................................................... By Beng Mortenson

Drugs have lost weight in the Colombian economy in recent years. While in the 80s, back in the days of Pablo Escobar and the Medellin Cartel, drugs like cocaine came to represent 6.3% of GDP, more recent studies suggest the currnt level might be as low as 1%. Part of this decline is due to the combined efforts of the authorities of the United States and Colombia against the traditional smuggling routes across the Caribbean, which has lead to the increasing use of land-based routes through Mexico, but also to the fact that legal industries like oil and mining have taken off and that, in general, during the years under President Uribe, the Colombian economy has gained significant momentum and security in the country has improved considerably.

Colombia has extradited hundreds of drug kingpins to the US

The agricultural and agro-drug trafficking does, however, still remains in Colombia, with the wholesale price of one kilogram of cocaine in Colombia being $ 2,200 in 2007 compared to some $ 31,000 in the U.S. or $ 59,000 in Europe. There are still an estimated 81,000 hectares planted with coca in areas under the guerrilla control, 51% of world output, but 44% less than in 2000, partly due to the reduced guerrilla control in rural areas. In last ten years the Colombian authorities have extradited more than a thousand Colombians to the U.S. to be tried for drug trafficking. Now it is the Mexican drug cartels that generate anywhere between 10 and 25 billion dollars annually, or about 2.5% of Mexican GDP, so the problem has been not solved as much as relocated. Meanwhile in Colombia’s benchmark peso bond yields have fallen to a four-year low following the central bank’s unexpected interest-rate cut. In fact the Banco de la Republica cut the overnight lending rate on April 30 to a record 3 percent low, while Central bank President Jose Dario Uribe said after the monetary policy meeting that while the economy is “recovering faster than expected,” and that the decision was based on slowing inflation expectations. The Columbian government expects the economy to expand 2.5 percent in 2010 following growth of

LATIN AMERICAN WIRE 0.4 percent last year which saw the country’s first recession in a decade. Inflation may well end the year at something like 3.3 percent, according to the median forecast in the central bank survey published last month: down from the 3.7 percent forecast in the March survey and well within the bank’s 2 percent to 4 percent target for this year. And of course, all this helps take some of the strength out of the peso

A home-made submarine once used to smuggle drugs in the Caribbean

(which has been LatAms second best performing currency — behind the Brazilian real — so far this year, helping growth in the country’s developing export sectors. Which all goes to show, virtuous circles are a lot healthier than vicious ones. Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net URL to article: http://www.globalspectator.net/?p=168

LATIN AMERICAN WIRE

Argentina – Spring K ........................................................................... By Rogelio Biazzi

Those relaxing walks through the streets of the American capital, enjoying the pleasant spring in the northern hemisphere, must account for the unexpected oasis of tranquility that the Kirchners are currently enjoying, after several months of political turmoil in Argentina. The president, her husband and a retinue of twenty advisers headed to Washington to attend the Heads of State Summit on nuclear security that Barak Obama recently organised. It is noteworthy that they arrived in the city three days before the start of the meeting without a justifiably busy schedule. The tour was in fact quite bucolic: long walks through the Georgetown and Foggy Bottom neighborhoods, a leisurely visit to the Smithsonian, a brief meeting with the American Supreme Court Judge Sonia Sotomayor, and gastronomic gatherings in some of DC’s most famous restaurants like the steakhouse Smith & or Wollensky. So what exactly going on in Argentina for the presidential couple to choose to spend so many days abroad without a better excuse than simply having a relaxing time? Until only a couple of months ago, the president was reluctant to leave

¡Primavera!

Buenos Aires for any reason whatsoever, as this meant temporarily transferring power to her vice president, Julio Cobos, one of the leading members of the opposition. In fact, only in January CFK cancelled an important trip to China, leading the Asian powerhouse, many analysts argue, to react by reducing its willingness to buy soya from Argentina. It seems that the Argentine government is currently enjoying a “rather timid” surge in its popularity, but mostly, they are standing on the sidelines, looking on with no little sense of relief at the way –with the forthcoming 2011 presidential elections now looming — that the opposition candidates are tearing themselves apart, thus making a positive outcome next year far more likely. The Kirchners know very well that “fishermen gain in turbulent seas,” and they have been preparing their boat-launch for some considerable time now. Last year’s defeat in the legislative elections seemed to have heralded a new twist in Argentinian politics and the beginning of the end of the presidential system, since it was

LATIN AMERICAN WIRE assumed that the significant victory of de Narvaez, Cobos, Carrie, and the Peronist Macris dissidents, would create a homogeneous and effective opposition. This was a big error of judgement: since the Presdiden’s opponents have not even been able to agree on a minimum joint parliamentary strategy, a failure which has led them to lose many a battle in Congress. And these battles should, a priori, have been feasible –or at least easy– to win. Returning to the K, they have now placed all their artillery on two fronts with one common thread: leaving the default behind and improving the country’s international political image, which has recently been simply disastrous. The debt exchange designed by Economy Minister Boudou is now in its final phase and the president hopes to ultimately achieve an agreement that will eventually offer Argentina the possibility of some access to international credit markets at a reasonable rate of interest. The Argentine president was in fact wrong-footed at the start of her US visit by the decision of Judge Thomas Griesa, who ruled on 8 April that Elliott Management and NML Capital could seize $105m in assets from the Argentine central bank [1], arguing that he doubted the real political independence of the central bank and stating that “Argentina has lost the good faith needed to operate in the financial markets.” However, the K overall strategy — which was really focused on ensuring that if 66% of the creditors accept the formal offer for the debt swap then the agreement would automatically be extended to those who continue to hold out and litigate in the US courts — met with rather more success, since Griesa ruled on April 26 [2] that it would be unreasonable to delay the proposed deal further at the request of a minority, since “this would involve the court in actions which could mean the class members are deprived of whatever opportunity the exchange offer affords with no assurances that so-called ‘improved’ offer would ever be made.” On the foreign relations side, Argentina needs to resolve the ongoing debate about what its place in the world really is, since it any form of clear alignment in an ever more complex global environment. It does not get on especially well with the United States but ties with China are also far from strong. It is not side by side with Cuba but it is not on especially good terms with the IMF, either. With dialogue with Russia is only formal and there was no Argentine ambassador in the United Kingdom for two years. It is close to Venezuela but distant from Iran, a key strategic partner for Venezuela. In short, Argentina must make up its mind whose side she is playing on, and whether she it is really business or ideology that matters at a time when she needs to find allies to help her out of her self-inflicted ostracism. The worst problem facing Argentina’s economy are undoubtedly its institutions, and their quality, as highlighted by Judge Griesa’s first ruling, and matters on this front are unlikely to improve much between now and the elections. The electoral arithmetic suggests that Kirchner needs to aim for at least 40% of the votes in the first round with no opposition candidate reaching 30% of the votes. Only in this way would he make sure of winning without needing to go to a runoff that he would surely lose. To do this he knows that his strategy is to keep the opposition divided and boycott all judicial or parliamentary attempts to limit their power. The betting man here would find little alternative to playing for the opposition team, in the hope they will be able to see that the only way to get the presidential couple out is by playing cards together. In this was we might just avoid having to witness a third Kirchner government, and this would be surely be good news for Argentines and Argentina alike. Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=91 URLs in this post: [1] who ruled on 8 April that Elliott Management and NML Capital could seize $105m in assets from the Argentine central bank: http://www.hfmweek.com/news/524347/hfmweek-daily-snapshot-8-april.thtml [2] Griesa ruled on April 26: http://www.businessweek.com/news/2010-04-26/argentine-dollar-bonds-gain-most-in-5-weeks-onjudge-s-decision.html

EURO ZONE ~ Spain

Chinese Money to Venezuelan Regime China has pledged 20,000 million dollars to Hugo Chavez. By Francisco Miranda

Posted by an elated Mr Chavez, the credit will count among the largest loans outside China and Beijing, and would confirm Beijing’s wish to strengthen ties with major oil producers, even with those as unpredictable as Mr. Chávez. China is the third largest oil importer in the world. Mr. Chávez complained that the U.S. was the largest buyer of Venezuelan oil. The loan is presented in Caracas as a first step to diversify exports away from American refineries. Chinese President Hu Jintao was not present at the pompous ceremony announcing the loan, citing the need to return soon to China to oversee aid to the provinces affected by an earthquake. The Chinese officials made no comments, either. Mr. Chávez needs money urgently. The infrastructure is in terrible condition and there is a shortage of electricity and drinking water. Venezuela has a 25% inflation, the highest in the region. Mr. Chávez said the Chinese money will be invested in new power plants, roads and other projects and would be paid in oil. There will also be a Chinese oil concessions in the Orinoco. The President and his fried

Ironically, U.S. consumers will gain. Oil is sold in an international spot market to the highest bidder and China’s willingness to give credit to the producers would increase supply and lower prices.

Mr. Chavez has already received and spent 8,000 million from China, which has been paying for oil. According to his version, he would be sending 460,000 barrels a day to China, but Chinese government figures show only 132 000 barrels per day from Venezuela. The battered Venezuela’s economy shrank 3.3% in 2009 partly by the falling price of oil. Most of the refineries that can process heavy Venezuelan crude are in the U.S. In 2009, Beijing adopted plans to build a refinery in the province of Guangdong in a joint venture with Mr. Chávez. The desire of the Venezuelan regime comes from the increasing challenges to the important legislative elections in September. They need the Chinese money for a tsunami of social spending in recent months, so as to recover, at least in part, the popular support eroded by shortages and rampant crime. The devaluation of the bolivar in January has helped little and the emission of millions of dollars in bonds to drain the demand for dollars has been unable to halt the steep decline of the national currency on the parallel market.

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The Long Sleep of Japan By Claus Vistessen

Still stuck in neutralâ&#x20AC;Ś Despite all the outward signs that the Japan has latched on well to the global recovery the economy is, in fact, still stuck in what is, by now, its well known rut of lacklustre domestic demand, falling prices, and ever rising government debt. The combination of a stagnant to negative trend in domestic demand and an overreliance on external demand in an environment of falling prices has proven to be an extremely toxic one for Japan, as withnessed by the sharp and sustained drop in output suffered during the recent global recession. On average Japan has lost 4.6% worth of nominal GDP each quarter since the second quarter of 2008, while the current price value of Japanâ&#x20AC;&#x2122;s GDP was 8% lower in Q4-09 than it was in Q4-07, and during the same period prices have fallen in 18 out of 24 months. In short; Japan is stuck in deflationary mire and the forward momentum of economic growth is now left entirely to whims of foreign demand which is channelled into growth through exports and foreign asset income. External demand dependence is a very volatile source of growth and especially so in world where the external deficits which are needed to accompany those Japanese surpluses are fast shrinking due to the deleveraging phenomenon. It has this become a big challenge for Japan to find reliable sources of economic growth. Some consolidation may be found in the fact that China continues to power ahead, unruffled by the fragile performance of all

ASIAN BAROMETER the main OECD economies, since Japanâ&#x20AC;&#x2122;s export to China have become an important lifeline, one which it is to be hoped will continue to prove a secure and stable one. So, while Japan is driven by exports that does not need to present an insurmountable problem as long as you are pretty good at it and retain your first mover advantage. The export supremacy of Japan goes back to the middle of the 1980s and in this sense Japan can tick off both these boxes with a firm yes. However, almost four decades of rapidly increasing life expectancy and extremely low fertility have taken their toll on the Japanese workforce, and what was once seen as the hallmark of a vibrant domestic economy has now become a structural vice in which Japan finds itself most decidedly trapped, as its continuing demographic malaise becomes a millstone preventing any form of sustainable domestic demand growth.

So far So Good? The French film La Haine tells the story of a group of socially disadvantaged young adolescents living in the suburbs of Paris and ends on a bad note when the leading character takes a fall from the 50th floor of a tall building. As he falls he says to himself â&#x20AC;&#x153;so far so goodâ&#x20AC;? as he passes each floor until, of course, he reaches the last one: the sidewalk.Japan may well be in a similar situation. The IMF estimates that gross Japanese government debt to GDP will hit a whopping 246% of GDP in 2014 and this forecast may even be on the low side given the persistance of deflation and the continuing decline in domestic demand. So far, Japan has been able to rely on domestic savings to get by, but as the population ages the Japanese, on aggregate, may begin to dissave and although the position is

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still far from clear, the prospect of Japan having to depend on foreign investors to finance the continuing issuance of domestic government debt securities would represent an unequivocal and decisive tipping point for Japanâ&#x20AC;&#x2122;s economy as we know it. From 1993 to 2009, the annual average running fiscal deficit stood at 6% of GDP, and while in current conditions this may in and of itself not sound as alarming as it should, the main problem Japan faces is that as it ages those ever smaller future young generations who ultimately will have to pay it all back will find themselves increasingly strained in trying to do so.

More ominously , as market discourse has shifted steadily and unrelentingly towards a focus on fiscal sustainability and looming pension liabilities, a series of recent comments and analyses suggest that Japan may well be edging closer and closer to that rendez-vous with the sidewalk. Firstly, Societe Generaleâ&#x20AC;&#x2122;s Dylan Grice (see here [5] and here [6]) has even suggested that Japan could face significant rollover risk for its government debt as early as 2010/11; and a recent piece by former IMF Chief Economist Kenneth Rogoff [7] has only added to the general feeling that Japan may well be headed for a Greek party of its own sooner rather than later. Finally, the Economist [8] invoked the idea of a crisis in slow motion as Japan seems unable to effectively deal with the double whammy of rising debt and continuing deflation. At the end of the day, all the attention which is suddenly being lavished on Japan is a direct function of the change in market discourse since end 2009 and of the focus on government debt sustainability and how countries are going to rein-in their fiscal policy. However, make no mistake. The concerns being voiced here and elsewhere are no idle speculation: they are real and well grounded in detailed analysis. Japan has not discovered the elixir of eternal debt, and simply cannot go on for ever and ever as it is now. Possibly being able to continually print debt in your own currency while your economy systematicall fails to fire up inflation may seem to be a boon, but something in

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the Japanese engine room is not working as it should, and one day or another it will become evident to everyone just what this something is. At some point the road will indeed come to an end. However, this time has not yet come, and thus when thinking about the Japanese economy the most important idea to take away is that there is an urgent need for a change in perspective, and a move from simply waiting for the inevitable pop to trying to understand the main characteristics of an ageing economy. As we have seen, these amount to having a deeply export dependent economy which just manages to keep the boat afloat on the back of a higher level of domestic savings than would normally be merited by the level of domestic investment demand and with this the perpetual attempt to generate an external surplus. This analysis suggests that Japan, far from forming part of the rearguard for a way of life which has to change is in fact in the forefront of the battle to address the impacts of societal ageing and more importantly, it suggests that the way it has been conducting this fight has had important repercussions on the global economy and the so called phenomenon of “abundant liquidity”. Thus the effect is most evident in the global consequnces of the Bank of Japan’s zero-interest-rate-policy, but can also be noted in the continuing propensity of Japan to save more than it invests, not because of a deliberate beggarthy-neighbour policy, but because this is only way Japan can maintain economic growth and keep its spiraling govenment debt burden under some semblance of control.Article available at THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=35

URLs in this post: [1] 2: http://www.globalspectator.net/?p=35&page=2 [2] 3: http://www.globalspectator.net/?p=35&page=3 [3] : http://www.globalspectator.net/?p=35&all=1 [4] Image: http://3.bp.blogspot.com/_ngczZkrw340/S9h_BVNHBKI/AAAAAAAAQmQ/jIH5r5Hkz1A/s1600/ Claus+Japan.png [5] here: http://ftalphaville.ft.com/blog/2010/03/08/167701/japans-brewing-fiasco/ [6] here: http://www.economist.com/business-finance/displaystory.cfm?story_id=15663864 [7] a recent piece by former IMF Chief Economist Kenneth Rogoff: http://www.project-syndicate.org/ commentary/rogoff66/English [8] the Economist: http://www.economist.com/displaystory.cfm?story_id=15867844

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China, The Megatrillion Question By Mikel Abasolo

China has withstood the global financial crisis much better than the rest. After slowing down to 8.7% in 2009, recently published figures show GDP growing 11,9% in the first quarter of this year. Every forecast points to China growing in excess of 10% in 2010 easily matching the rates seen in much of the last decade. The government implemented a phenomenal fiscal and monetary stimulus that has been successful in compensating the export collapse with investment –90% of growth in 2009 came from investment, most of it property and infrastructure spending-, with little damage to the solvency of the public sector –the official budget deficit was less than 3% last year, leaving the public debt to GDP ratio at 17%-. For the China bulls central, command of the banking system has clear benefits as all this was made possible thanks to credit growing some 30%. In contrast to most developed nations, Chinese banks have shown few signs of strain during the recession. Non‐performing loans are well contained at low levels, and even if understated, would have to go up a long way to be a concern, and even then, the capacity of the state to bailout the banks as it did in the aftermath of the 1997 Asian crisis, looks huge. If the previous successful experience of East Asian countries –and the Soviet Union and satellite countries for that matter-, is any guide, the China story is not over. Then as now, growth rates were impressive but could be completely explained by rapid growth of inputs, that is, the increase in labor supply and, more than anything else, massive investment in physical capital. The problem is that the willingness to forego current consumption for the benefit of a better future has clearly identifiable limits. As Paul Krugman explained in 1994[1] [3], economic growth that is based on mobilization of resources, rather than growth in efficiency, is inevitable subject to diminishing returns. It is well understood that input-driven growth is an inherently limited process. Not that China is not becoming or will not be able to become more efficient. But for that it will have to succeed where many have failed before, and in any case, knowledge and technology will not allow it to sustain present growth rates indefinitely, even if the country enjoyed a

ASIAN BAROMETER far more favorable demography than it does. Not only that, the road to riches for China is likely to bring with accidents. For one thing, not many centrally-controlled banking systems have been transformed into a privatesector banking system without a significant crisis. That is because this transition forces money, credit and assets to become correctly priced and that always means a very painful realignment for the owners of assets. A centrally-controlled financial system promotes certainty, but at the price of massive distortion of capital allocation. In China, GDP growth is not the spontaneous outcome of the economic process, but the object of policy.

The redeeming chinese bulls? Negative interest rates in a country with 10% GDP growth builds momentum for that growth but it creates all types of risks. Capital is badly spent during the euphoria. Companies and households will inevitably rationalize investing in projects with unclear and distant returns like housing, airports and toll roads. Fixed investments in China are now in excess of 50% of GDP, an unsustainable level in the long term, never reached by Japan or Korea in the ’70s. It is assumed that if you go beyond 30% you are in seriously overheated territory. Only during the bust does the extent of the misallocation become apparent and the excess supply visible –weren’t Spanish real estate developers still enjoying the party in early 2007?-. The distortion of a stateowned banking system is further distorted by a policy of export-led growth. An undervalued exchange rate depresses consumption growth, but more importantly it creates excess money, with the usual accompanying distortions. Having grown so large, mispricing in China is on a massive scale. As Russell Napier[2] [4] states, “There is an individual in China who on any given day can determine the price of money, the quantity of credit/money and the exchange rate. That one person, it seems, can do accurately for China what a myriad of highly paid market professionals fail to do for the USA!”. But export-led growth for China will hardly be as easy as option as it has been in the past, simply because a model whereby the American consumer takes on ever more debt to buy Chinese cheap goods looks exhausted. China is too big. The country is at the epicenter of the massive global economic imbalance that is unlikely to persist. The transition from an export-led growth model to a consumption-based one is a structural shift, and as such comes with a much greater risk of social and economic stress. Con-

ASIAN BAROMETER vinced China bulls are sure that continued robust growth will redeem all the above sins. Demand for everything will absorb the excess capacity built in everything, empty cities will come to life and all the underwriting mistakes made as credit expands at 30% per year will be forgiven as the passage of time will turn bad loans good ultimately. Moderate bulls acknowledge the imbalances built into the Chinese economy and admit that the day of reckoning may well come to pass at some future point but they are confident that it won’t be soon. According to this view, over the Fixed investments in China are now in excess of 50% of GDP, an time horizon of most investors, it unsustainable level in the long term, never reached by Japan has a low enough probability of occurrence that people should or Korea in the ’70s. It is assumed that if you go beyond 30% not pay much attention to it. you are in seriously overheated territory. Only during the bust The successful response to the does the extent of the misallocation become apparent and the last crisis has surely reinforced excess supply visible. the confidence of investors in the ability of the country’s rulers to steer the economy onto a sustainable path. For the bulls, China has considerable room to maneuver to delay a reckoning: ample reserves -which did not prevent Japan from falling off a cliff in the early ‘90s, and still unused labor and capital inputs. By contrast, China bears find many of the traits of a big bubble. Bubbles they say, always burst, the question being when. For them, China is a “supply now, consume later” economy that very much resembles the “new economy” of the internet bubble era were colossal investments in fiber optic cable were needed in advance of explosive growth. The fact that China is not a pure market economy makes the likely fall all the more painful as imbalances can be managed to grow larger. As in Japan in the late ‘80s, the bears think that the China story is built in the assumption than past growth rates will continue into the future. But then, as now, extrapolating an impressive past into the distant future is liable to a disorderly outcome. Krugman surely agrees.

[1] [5] “The Myth of Asia’s Miracle”, Foreign Affairs, Nov/Dec 1994 [2] [6] “Buy chaos, sell order”, CLSA, March 10th, 2010 ArticleAVAILABLE AT THE GLOBAL SPECTATOR: http://www.globalspectator.net/?p=3 URLs in this post: [1] 2: http://www.globalspectator.net/?p=3&page=2 [2] : http://www.globalspectator.net/?p=3&all=1 [3] [1]: http://www.globalspectator.netfile:///F:/Reserve/China%20Spectator_18%20Apr%2010.docx#_ftn1 [4] [2]: http://www.globalspectator.netfile:///F:/Reserve/China%20Spectator_18%20Apr%2010.docx#_ftn2 [5] [1]: http://www.globalspectator.netfile:///F:/Reserve/China%20Spectator_18%20Apr%2010.docx#_ftnref1 [6] [2]: http://www.globalspectator.netfile:///F:/Reserve/China%20Spectator_18%20Apr%2010.docx#_ftnref2

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More On China’s Real Estate Bubble: The Magic Goose By Kim Polder

The Chinese government is currently intensly focused on the country’s overheated real estate sector and trying hard to find more effective and stringent measures – such as tightening mortgage loan terms – which will slow the sector down without harming general consumer demand. While the 30% discount available on mortgage interest for first-time home buyers has been reduced, second-time home buyers have been hit even harder, because they are experiencing a total roll back of discounts on interest (interest charged now can’t be lower than 110 percent of the benchmark rate) and their down payment has been raised to 50%. The third-time buyer, assumed to be a mere investor, has seen the down payment raised to 60%.

Business as usual? A “normal” property analyst reading the above paragraph might find the situation described pretty hard to understand. But in China the situation is quite the different from the “normal”. Of course, the immediate impact of the above policies have been as expected i.e. the real estate market has registered a fall in sales volumes. But property investors are not in a state of discouragement and disinvestment frenzy. Even those who make their living from selling and buying properties are taking these policy measures calmly. Why might this be? Their sense of calm and peace is derived from real estate history based on the old proverb that you can’t kill a goose that lays golden eggs. Here in China that goose is the real estate market and it lays many and quite substantial eggs. The Chinese government has taken some strict measures in the past too with the avowed intention of limiting rampant speculation in the housing market. But investors have got used to see such measures retracted when the government started to feel the adverse repercussions of the policies. After all, beyond the foolishness of killing magic gooses, you can’t cut off the branch you are sitting on. Now the logical question is how the Chinese government managed to land itself in the proverbial soup? If we take a closer look at the real estate market in China, the first question that naturally arises is how people are able to buy property? Another question is where exactly the down payment money comes from? The answer is fairly simple. Local governments borrow from banks and use that liquidity to pay compensation to residents who are forced to resettle. Local governments pledge the property to the banks. Armed with the compensation money, resettled residents are able to shell-out the down payment and buy the new property. A magic circle or a vicious one? Maybe both but in any case it is a circle, the sort of self-feeding processes that bubbles are made of.

ASIAN BAROMETER

India: Tighten Your Seat-Belts For A Not-So-Bumpy Ride .................................................... by Amrit Hall

Bank credit is expected to start flowing soon into Indian infrastructure projects following the decision of the Reserve Bank of India (RBI) to reduce the level of bad loan provisioning required for the sector from 20% to 15%. The move is being interpreted as tangible evidence that this time the Indian government is irrevocably commited to tackling the countries chronic infrastructure deficit. Infrastructure compaIndia’s inflation is in part the result of strained infrastructure. The nies like state-owned country produces about 10 percent less electricity than it needs, Rural Electrification Corp, while roads, which account for 65 percent of freight transport, are Infrastructure Development Finance Co and plagued by single lanes and irregular surfaces, causing snarl-ups, dePower Finance Corp rose lays and breakdowns which all add to company costs. sharply following the announcement. India has said it plans to double spending on building utilities, roads and ports to around $1 trillion in the five years ending 2017 in an attempt to boost economic growth without fuelling inflation. The decision was described as “pro-infrastructure,” bySunil Agarwal, managing director at Deutsche Bank AG in Mumbai. The central bank’s move “would help long-term borrowing, especially from infrastructure companies, who should look for longer terms for their borrowing. Banks now should be more prepared to lend, he said” Indian utilities are planning to almost double generation capacity over the next seven years and as Mumbai analyst Jaynee Shah says, “even if you assume that only 75 percent of it actually comes up, there would be a tremendous amount of investment required by the power sector”. It is evident that if India’s growth rate has to touch and maintain double digits Prime Minister Dr. Manmohan Singh’s government will need to give priority to ensuring that the lion’s share of future investment goes into infrastructure. India’s inflation is in part the result of strained infrastructure. The country produces about 10 percent less electricity than it needs, while roads, which account for 65 percent of freight transport, are plagued by single lanes and irregular surfaces, causing snarl-ups, delays and breakdowns which all add to company costs. India’s Prime Minister said last month that the last two years had been especially difficult for the Indian economy given the shock from the global recession taking its toll, and the sharp surge in inflation which followed the drop in food production produced by last year’s disappointing monsoon rains. That being said, he also noted that India had, inspite of everything managed to maintain steady growth above the 7% level, and that the target now would be to move towards sustainable growth of 10% in the near future. India’s population deserve nothing less. Evidently such high growth requires massive infrastructure investments and, most significantly, Singh stressed the need for a far greater level of private sector participation. These priorities are embiodied in a government infrastructure appraisal document which will now go

ASIAN BAROMETER before the National Development Council (NDC) for review before the federal and state governments start acting on its recommendations. The NDC is a pan-Indian, high-powered body comprising the Prime Minister, chief ministers, lieutenant governors and members of the Planning Commission, and examines policies on infrastructure, rural development, investment, fund mobilisation, labour, food security, agriculture, environment and regional balance. Speaking at an infrastructure conference recently, India’s Prime Minister was pretty specific and spoke of the urgent necessity of doubling infrastructure spending, targetting a grand total of US$1 trillion over the five-year period starting April 1, 2012. He said that such investment was necessary to catapult India’s growth rate to double digits. Dr. Singh said that while the annual growth rate had been 6.7% and 7.2% in 2008-09 and 2009-10 respectively, he now expected the economy to turn in 8.5% and 9% growth in the next two years. There is a wide consensus among experts that India’s crumbling infrastructure adversely affects the growth rate by as much as two percentage points. India, which is Asia’s India had previously projected infrastructure investments of $514 No.2 economy, had premillion in its Five Year Plan target for March 31, 2012, but the global viously projected infrastructure investments credit squeeze drastically slowed progress. However, the general imof $514 million in its pression is that India has weathered the recession better than most Five Year Plan target for developed economies and should therefore attract substantial fund March 31, 2012, but the inflows in the years to come global credit squeeze drastically slowed progress. However, the general impression is that India has weathered the recession reasonably well, and certainly better than most developed economies. The country should therefore be exected to attract substantial fund inflows in the years to come. However despite the recent elated mood, inflation has once more raised its ugly head (wholesale prices were up an annula 9.9 percent in March), forcing the Reserve Bank of India (RBI) to raise repo and cash reserve rates by 25 basis points each in an effort to suck excess money out of the system and slow demand-side pressures. The repo rate, the rate at which commercial banks borrow, now stands at 5%, while the cash reserve ratio has been moved up to 6%. Consequently, loans from banks are now about to become both costlier and harder to come by. “We are alert to the possibility of overheating,” RBI governor Duvvuri Subbarao told analysts in a conference call following the decision. The central bank will ensure that “investment is supported, so, as demand is increasing, supplies are indeed ahead of demand, and we don’t have overheating.” Subbarao also cited rising energy costs.as a problem. India imports roughly three-quarters of the oil it needs, and is as much of a risk to inflation as the monsoon rains are, especially since crude prices have surged by over 80 percent in the past year. As Avinash Gupta, a New Delhi stock analyst said, “It’s a delicate balancing act by the central bank .The government isn’t willing to sacrifice growth while at the same time cutting the fiscal deficit and controlling inflation. The stock market is likely to be choppy.”

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WE TOLD YOU SO -

THE GLOBAL SPECTATOR

FEB 10

A reflection and an announcement

To explicitly state “We told you so” is the kind of self-indulgence frowned upon by the purists of journalism. It’s considered bad style, presumptuous and a put-off of sorts. Yet, in these times of ours, purism is one of the many luxuries that we can’t afford, least of all business journalists and economists. This is why the editor has decided to include in this issue two articles from the archive of The Global Spectator, two upsettingly prophetic pieces on Spain -and by ricochet Europe- by Edward Hugh. The first one, published in September 2009 under the evocative title “A specter is haunting Europe”, sounded the alarm about the Spanish economy and, concomitantly, Europe’s institutional structure being “scarcely prepared for such a nightmare eventuality.” And it called for urgent reforms in Spain and for the European leaders to do something about the procrastination of the Spanish government. The last paragraph of the article summarized the frustration of the author: “And meanwhile, from their Towers in Brussels and Frankfurt those who are really responsible for Europe’s decision-taking are forced into the frustrating position of being mere spectators, forced to come in later and extinguish the fire but without access to the direct policy levers which would have enabled them to put the blaze out before it really got started.” [LINK] Five months later, the second article, “Lost in the Bermuda Triangle,” timely posed the question of whom -if anyone- was in charge of Spain’s economy. This was the moment when Spanish Public Works Minister José Blanco decided to go on the record with the claim that his country was victim not just to a strong speculative attack but also to an ‘Anglo-Saxon press’ lead plot to destroy the euro. Edward Hugh wondered: The (Spanish) government now projects a 1.8% gain in GDP in 2011, with growth in 2012 up as high as 2.9%, from a prior 2.7%. Of course, you can pull numbers (like rabbits) out of any hat you like, but that won’t bring you growth, and certainly nothing like 3% growth in 2012. So we are heading towards trouble, even as the Brussels control tower seems to be having difficulty maintaining contact with the pilot and his crew. [LINK] Since the beginning of the big recession in early 2007, Spain has been a country in denial, governed by people offering the best of themselves to negate the very existence of the crisis and to keep their fellow countrymen in the dark. The Spanish socialists apparently believed that they could wait the downturn out spending on unproductive public works as if there were no tomorrow, in fact heaping debt upon more debt onto future generations. Hugh could have titled his first piece “Chronicle of a Meltdown Foretold,” and the second “Clamors of a Voice Crying out in the (intellectual) Desert.” But maybe part of the Zeitgeist of the time is a generation of deaf and blind politicians that neither understand, nor want to understand, this global world of ours. A Zeitgeist that produces a bureaucratic nightmare in Brussels, a wave of self-centeredness in Germany, a rationalistic trance reverie in France, and a Spain where Mr. Zapatero’s taste for existential philosophy combined with an absurd gift for the over-dramatic simply conjures up a modern variant of the theatre of the absurd, simply leaves us with a virtual world which cannot be logically explained. Well, we did tell you so. The Spectator will continue to try, in all fairness, to make sense of the “how”, “why” and “who” of what takes place on the global economic stage, no matter who the playwright is. All this to tell our readers that from the next issue of the Global Spectator, Edward Hugh will serve as our European Editor. May the Force be with him…

WE TOLD YOU SO - SEP 09

We Told You So - Sept 09

Spain’s Economy

The Spectre Which Is Haunting Europe By Edward Hugh

A spectre is haunting Europe, but it is not the spectre of revolt by the popular masses, or even one of yet another wave of bank bailouts, no the spectre which is currently haunting Europe most is one of a Spanish economy which stays on a flatline while Europe’s other economies, one by one, start to struggle back to life. And the main reason that this particular ghostly image is giving everyone so many sleepless nights is because Europe’s current institutional structure is scarcely prepared for such a nighmare eventuality.

WE TOLD YOU SO - SEP 09

Europeâ&#x20AC;&#x2122;s Architectural Deficiencies Decision making in modern Europe stands on two legs. On the one hand, as far as fiscal decisions go we have the European Commission whose powers are shortly due to be extended by the all important Lisbon Treaty. Even this rather modest step forward, however, remains bogged down in dispute, since it still has not been ratified by all existing EU member states, and in particular by the all important Eurosceptic group of Ireland, the Czech Republic and the UK. On the other hand when it comes to monetary policy the powers of the central bank (the ECB) are severely restrained (at least in theory) by the terms of the Maastricht Treaty which as well as creating the bank also established the EU itself as a legal entity. The present Spanish government is - like all EU governments - being given a wide margin of manoeuvre in how it handles the crisis by both the long suffering EU Commission and by the ECB - there is scarcely an option given the degree of sovereignty the member states still retain - but this degree of tolerance will surely not last for ever, and the present increase in the Spanish debt will not be allowed to survive unchecked into 2010 and beyond. So push is steadily coming to shove. Spainâ&#x20AC;&#x2122;s economy is suffereing from rather more serious problems than the majority of its West European counterparts, since before the global financial crisis broke out Spain had already experienced one the most serious housing and construction bubbles in the short history of our planet. This bubble produced all manner of long term problems including a very high level of corporate indebtedness and a large loss of competitiveness in Spainâ&#x20AC;&#x2122;s industrial and service sectors.

WE TOLD YOU SO - SEP 09 So not only does Spain now need to shut down much of its construction capacity, it also needs to find external customers for its largely overpriced products. But rather than address the underlying issues, Spainâ&#x20AC;&#x2122;s present government has chosen to try to hold steady on a straight course, in a vain attempt to grin and bear it, and ride out the current global storm intact in the rather naieve hope that things will simply sort themselves out once global activity returns to normal. The result of all this procrastination is Spain may now be forced to face the worst of all possible worlds, in that not having carried out the much needed correction during the years of tolerance, when interest rates were near to zero, bank liquidity was plentiful, and the government capacity to sign cheques had virtually no limit, it will now how to do so in a world were none of these cushioning factors are present. Simply put, Spain will face the most serious problems should the rest of Europe begin to recover, interest rates start to rise, liquidity provisioning at the ECB be gradually turned off, and those all important government subsidies in the other EU countries - which have so helped Spainâ&#x20AC;&#x2122;s struggling automotive sector - come to an end. Only one final coup de grace will be wanting, and this as we will see may not be long in coming: a much stricter excess fiscal deficit procedure from the EU Commission.

Recovery Europe?

Meanwhile talk of a Eurozone recovery continues. The end of September saw a heavy slew of data, including the business surveys for September and the summerâ&#x20AC;&#x2122;s consumer spending numbers from France. The data continue to support the idea of continuing recov-

WE TOLD YOU SO - SEP 09 ery in the third quarter but suggest that the economy is not building up as much underlying momentum as was prviously thought. In France, the latest household consumer data pointed to 1% monthly falls in spending in both July and August as a rebound in inflation and further job losses continued to weigh on consumption. The untick in French inflation while price index numbers remain lodged in negative terrirory in Spain, Ireland, Finland and even Germany, constitutes just one of the rapidly looming headaches for the ECB. The weaker French consumption trend was, however, offset by a fairly solid performance in both the industrial and service sectors, with the PMIs powering above the critical 50 level. Similar improvements were not, however, matched in Germany, where both the IFO survey and the PMIs came in below expectations. So France, far from being a harbinger of things to come, may well turn out to be an exception in a region characterised by stagnation (at best) or continuing sharp contraction (Ireland, Finland, Spain). Hence the only good news for Spain at the moment seems to be that the whole economic and financial system will be put to the test rather later than anticipated, but it will, eventually, be put to the test. Just this cautiousness about the fagility of the recent stabilisation in the Eurozone was underlined by Bundesbank President, Axel Weber in an interview with Market News. Mr Weber was at pains to stress that he still considers the current level of interest rates to be appropriate and that it is still far too early â&#x20AC;&#x153;to exit the currently extremely loose monetary policy.â&#x20AC;? He also warned that the recovery will be

WE TOLD YOU SO - SEP 09 “very sluggish”. Mr Weber placed considerable emphaisis on the behaviour of bank credit, stating he did not expect any turnround in the present decline before mid-2010. Clearly this is likely to be the decisive indicator for the ECB to begin withdrawing liquidity. “As we come out of this crisis and as the economy recovers and as the credit cycle turns, I think we do have an obligation to decisively counter long term inflation risks,” he said.

Demand Deficiency In Spain? Spain is, as I say, suffering from a serious deficiency in internal demand. The latest retail sales figures (July) continue to confirm the ongoing decline, with sales down 1.2% month on month over June, and 6.47% over July 2008. Sales are now down 10.11% over their November 2007 peak. Spanish construction fell again between May and June, despite the omnipresent plan E, falling 0.2% on the month. Year on year figures are now virtually meaningless for an industry which had been contracting for three years as of last July, but from the peak activity is now down by around 30 - that is it is the industry is now roughly 70% of what it used to be, and there is still a lot further to go. Industrial output continued to fall in July, and was down 17.4% year on year, which means it has now fallen nearly 35% % from the June 2007 peak. With the collapse in internal demand Spain’s government has been compelled to come in to support the economy. Such intervention is entirely justified, since without it Spanish living standards would be falling dramatically, but behind the spending there should be a plan, and this is really what I find missing in the Spanish case. Spain’s economy has become demand deficient because all the main groups of domestic economic agents are steadily trying to cut back on spending and debt, and the export oriented sector, after years of neglect and internal price inflation, is now just not competitive enough to make up for the gap. Worse, given this, investors are not exactly queueing up to put money into new export capacity, which would be about the only other source of growth the Spanish could look for at this point. And it is at this point where we come back to the deficiencies in the EU institutional structure. Since Spain’s central bank is effectively only a regulatory bookeeper, it is the ECB which has the responsibility for improving the liquidity position of Spain’s banks. And the big news here is that the ECB is - whether wittingly or unwittingly - indirectly funding Spain’s fiscal deficit via its liquidity provision. Data is a little hard to come by but if we look at what we have then we find, surprise surprise, that banks

WE TOLD YOU SO - SEP 09 in countries that have experienced large increases in government debt issuance (and which had previously been subjected to wide spreads versus the benchmark German equivalent bond) have been very active in supporting their own domestic debt markets this year, and at the same time the spreads have fallen back. In fact the financial system which has been the largest purchaser was, well guess who, the Spanish one since Spanish MFIs have been steadily buying around €9bn a month worth in recent months - strange how that number nicely covers just what is needed for the current account deficit, isn’t it? Another piece of circumstantial evidence for the fact that the ECB is funding Mr Zapatero comes from the detail that Spain’s share of the 442 billion euro June 24 one year tender represented something over 15% of the total, while the Bank of Spain share in the Eurosystem is just over 8%. And of course, while Spain’s banks are busily running up their debt levels at the ECB, both corporate and household borrowing are either flat, or trending down. So just ask yourself, where is all this money going? And if we look at the spreads on Spanish Another piece of circumstantial evidence for the fact that the ECB is government debt for a funding Mr Zapatero comes from the detail that Spain’s share of the moment, it is clear that, 442 billion euro June 24 one year tender represented something over in the Spanish case at 15% of the total, while the Bank of Spain share in the Eurosystem is least, the recent tightening of the spreads is just over 8%. And of course, while Spain’s banks are busily running up direct knock-on consetheir debt levels at the ECB, both corporate and household borrowing quence of ECB liquidity are either flat, or trending down. So just ask yourself, where is all this provision. In fact, the money going? extra interest that investors demand to hold Spanish debt rather than the German equivalents is now hovering around 51 basis points, a premium which is four times greater than it was at the start of 2008, but well down from the record 128 basis points gap hit in February. And if we look at the actual dynamics of the Spanish economy it is evident this can have little to do with any improvement in those so called “fundamentals”. All of this is an illustration of just one of the reasons why the Maastricht Treaty tried to tie the ECB hand quite strongly, but of course, even the most closely written documents fall apart if the pressure on them is sufficiently great. Not that Brussels and Frankfurt are unaware of the problem, it’s just that finding a way forward here is difficult within the existing framework. The Head of the Spanish debt agency has been changed in recent days, and the former incumbent of his position has been moved to the Spanish permanent representation (read Embassy) in Brussels in a way which suggests that someone (presumeably Joaquin Almunia) is trying to get a hold on something (the process of Spanish debt issuance), and there is no doubt that some hard talking has been going on behind the curtain. Spanish Economy Minister Elena Salgado recently announced that the deficit target for the 2010 budget was now going to be be 8.1%, chipped down from an earlier objective of 8.4 percent, so someone, somewhere is whittling away. The Spanish government is being forced to increase value-added tax to 18% from 16% from next July, in the first step on a longish path towards the sort of programmes we are seeing implemented under EU/IMF auspicies in Ireland and Eastern Europe. Gross Spanish government debt is now forecast as reaching 62.5 % of GDP in 2010, dramatically up from the 40% level of 2008. But a lot still depends on this year’s public- sector deficit, which is currently forecast at 9.5 % but could easily come in at 12% or more, depending on the rate of economic contraction in the second half of the year.

WE TOLD YOU SO - SEP 09

Is Spain the New Japan?

Spain, according to Variant Perception’s Jonathan Tepper, has now become a second Japan since the Spanish government continues to plaster the country with cement in an attempt to keep a moribund construction industry alive, while the country’s banks still refuse to recognize their true losses, in the process starving potentially profitable sectors of much needed working capital, just as the Japanese banks did between 1992 and 1995. By continuing to fund the economically weak, the so called “zombie” builders and developers - they still have €52 billion in funding set aside to help build yet another million undigestible housing units according to the The Spanish government continues to plaster the country with cement in latest report by an attempt to keep a moribund construction industry alive, while the counMadrid-based try’s banks still refuse to recognize their true losses, in the process starving real estate anapotentially profitable sectors of much needed working capital, just as the lysts R. R. de AcuJapanese banks did between 1992 and 1995. By continuing to fund the ña & Asociados - Spain’s banks economically weak, the so called “zombie” builders and developers - they are not providstill have €52 billion in funding set aside to help build yet another million ing capital to undigestible housing units other companies that desperately need it. And in this way viable businesses are being strangled by a lack of liquidity and financing. In addition, by becoming owners of large stockes of property the Spanish banks are putting their balance sheets at severe risk in the future. The same point was ably made earlier this year by Daniel Villalba, catedrático de Economía de la Empresa de la Universidad Autónoma de Madrid. As Villalba says when faced with a delinquent developer, Spain’s banks have two simple alternatives. They can either go for the direct route, and simply have the enterprise declared bankrupt, taking their

WE TOLD YOU SO - SEP 09 chances on what they will get when the properties the developers offered as guarantees are put up for auction, or they can exchange the properties for a price exactly equal to the outstanding debt plus interest - the so called dación en pagos. The difference between the two approaches is that while in the first case the bank’s bad loans rate shoots up, in the second the bank removes a potential bad loan and has no current loss to declare, since the law does not oblige the bank to value the asset at market prices following the introduction of the new accounting regulations. But the second solution has great weaknesses and presents important future risks, in that the banks may eventually be forced to put some of these newly acquired assets on the market at prices far below present valuations. As Villaba says: “Seven or eight years after the crisis broke out, the Japanese government was forced to clean up the banking system. But during the years prior to the cleanup the Japanese banks really were zombies, zombies which continued to function. Everything now seems to point to the fact that we in Spain are following along the same path of the Japanese ‘lost decade’.” We already have the zombies, while at the same time productive businesses simply wilt on the vine for lack of working capital, and in many cases die. And meanwhile, from their Towers in Brussels and Frankfurt those who are really responsible for Europe’s decision taking are forced into the frustrating position of being mere spectators, forced to come in later and extinguish the fire but without access to the direct policy levers which wouldhave enabled them to put the blaze out before it really got started.

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WE TOLD YOU SO - FEB 1010 WE TOLD YOU SO - FEB

Does anyone know who's flying that plane? By Edward Hugh

The main problem facing the Spanish government now is credibility, and what to do about the impression that the national airplane is flying pilotless over that perilous no-contact zone If Greece is broke, can Spain be far behind? This question put by the Economist to its readers only last week, is surely one many investors and financial market participants are busily asking themselves at this very moment in time. The Economist's own ambiguous answer was hardly surprising, since as they point out while Spain is evidently not a Greece at this stage, there is no shortage of things to worry about. In fact saying you are not actually as bad as the current worst case scenario is not saying all that much, indeed it doesn't even reassure anyone that that least desired of labels might not eventually befall you one of these fine days. Certainly, ever since Spain's Public Works Minister José Blanco came out with the claim that country is the currently victim not just to a strong speculative attack but also to an “Anglo-Saxon press” lead plot to destroy the euro the rhetorical temperature has only risen and risen, as each of the respective party desperately tries to fend off the attacks of the other. Perhaps the most striking example of this particular war of arguments is to be found in what is surely the latest-generation twist in the old dialectic of blow against blow, where a combination of internet age communication systems and sophistocated data management software furnish yet one more dimension to the current crisis debate: let's call it the birth of the "charts war". And from what we've seen so far it looks to me like the Spanish craft just got itself shot down in the nether nether land. I think you it would be safe to say that it was Nobel Economist Paul Krugman who kicked off the latest round in the ongoing war of graphs with one simple image on his New York Times blog, one which showed Spain's rising unit labour costs as compared with those to be found in Germany.

Finance Minister Salgado suggested that adding 2 million unskilled workers to the Spanish dole queues, and closing down a large chunk of Spain's core construction industry (driving the unemployment rate up to 19.5% in the process) has not been all bad. PUBLISHED: FEBRUARY 2010

WE TOLD YOU SO -

FEB 10

Foul Play? The Kindom of Spain was not amused, cried foul, and struck back during their London roadshow (courtesy of Finance Minister Elena Salgado and her second in command Manuel Campa) with their own version of the same topic. Spain is not so badly off we are told, since Italy's position is even worse. Adding insult to injury, they went one step further, Spain & Germany Gross Government Debt Compared and suggested that adding (Annual / GDP) 2 million or so unskilled workers to the Spanish dole queues, and closing down a large chunk of Spain's core construction industry (driving the unemployment rate up to 19.5% in the process) has not been all bad, since in some senses it has been extremely beneficial, given that cleaning out all those low productivity, unskilled workers has meant that the productive power of what is left now looks decidedly better (since the average productivity of those still in work has notably risen). It is like saying that wartime bombing is beneficial if what it does is destroy the oldest part of your housing stock. But this exit of so many workers from the centre of the economic stage is just where Spain's fiscal deficit problem enters, since those workers who are unfortunate enough to find themselves unemployed are still being supported by the rest of the Spanish labour Spain & Germany Fiscal Balance Compared force via their contributions Annual / % GDP to the Spanish social security system, and the output loss is hitting the government balance sheet hard via the drop in tax revenue. So the productivity improvement (as far as Spain as a whole is concerned) is simply an optical illusion. It looks nice on one graph (the unit labour cost one) and horrible on another (the government fiscal deficit one). This is a point that Paul Krugman could have pickedup-on but didn't, although he did follow through with a further post full to the brim with very revealing charts, all intended to demonstrate that Spain's core problem is not essentially a fiscal one, a point which may be clearly seen from a comparison of German and Spanish fiscal deficits over the last decade. As Krugman argues, Spain had no evident fiscal problem

WE TOLD YOU SO - FEB 10 till the housing boom went bust - it had a monetary one in that the interest rates being applied were far from the adequate ones, but the ensuing boom that these produced meant that the government's treasury accounts were generally awash with money. Then, naturally, it all went "pop". Now the need to prop up the economy, and support all that "unproductive" labour which doesn't show up in the unit labour costs chart is producing a massive fiscal deficit. Thus the fiscal issue in Spain is a symptom, not a cause. The root of the problem lies in the structural distortions produced by the massive overheating of the economy during the boom years, an overheating which lead to excessive inflation, largescale dependence on imports, and a complete loss of competitiveness in the non-tradeable sector - a loss of competitiveness which even the Kingdom of Spain accepts.

ECB Financing for the Spanish Banking System Billions of USD

The problem with the Spanish government argument is that it focuses on the idea that the tradeables sector is not that uncompetitive. But this seems to neglect the rather inconvenient fact that those workers who are deployed in the tradeable sector also eat bread and go to hairdressers and ride in taxis and buy or rent homes just like everyone else. So they themselves need to pay prices set in the non-tradeable sector, and their salaries have to reflect this. Hence a problem in non-tradeables becomes a much more general one. And it shows up, naturally enough, in the tremendous hole in the current account balance. The Kingdom of Spain, however, goes Spain's Trade Deficit even further, and suggests that far Monthly, Bns of USD from being subject to a continuing deterioration Spain's tradeables sector (on aggregate) has maintained its share of world trade over the last decade. But there is something intuitively wrong with this argument, and what that something is becomes evident if you consider that Spain was running a growing trade deficit over the whole period in question. Now global imports = global exports (by definition, trade is zero sum) and since Spain's trade deficit deteriorated over the period imports grew more than exports. Thus logically Spain's import share grew more than it's export share in world trade. That is Spain became a growing force in world IMPORTS. Somehow no one from the Kingdom of Spain mentioned this inconvenient little detail during their London since the country's representatives seem to be more focused on winning arguments with the perceived enemy - the Anglo Saxon press - than on finding real solutions to real problems. There is also a simple explanation as to why Spain's tradeable sector gives the appearance of being so competitive, and that is the non-competitive parts were simply driven out of business, and the demand for their products

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was met by imports. And this is just why Spain's current situation is so unsustainable. To get back to growth Spain has to start supplying a higher percentage of its own needs internally, and it has to find work for a large number of low skilled workers, and there is simply no way round the issue.

Smokin' Gun Indeed, analysts at PNB Paribas recently took the competitiveness loss argument one step further and, by examining the virtual Real Effective Exchange Rates of the respective countries, showed how, far from addressing the competitiveness issues in Greece and Spain, the recent bout of fiscal spending was in fact making the situation worse. This is a point I myself have been trying to make by using two simple charts. The ECB eased liquidity in the Spanish banking system last June with a massive injection of one year funding. This money went, via bank purchases of Spanish Treasury Bonds, to fund the government deficit, leading to a large injection of demand into the real economy. But what happened to that demand? Just look at the accompanying chart. The trade deficit started to widen again, as Spaniards availed themselves of their additional spending power to buy yet more foreign products. So essentially the issues is this one. Spain's economy will not recover, and will not return to sustainable growth till Spanish products become much more attractive in price terms, and this only means one thing: some sort of internal devaluation, and all that talk we keep hearing about an exclusively fiscal correction is simply an attempt to remove the smoke without going to the trouble of extinguishing the fire which is producing it.

Spain Is A Serious Country Meanwhile José Luis Rodríguez Zapatero, Spain’s prime minister continues to try to reasure his European partners and financial markets alike by telling them Spain is "a serious country and we will fulfil our promises.” In other words, despite the severity of the recession the country is currently suffering, and the major challenges facing its banking system, Spain, as the Economist would agree, is not about to become another Greece. At least, not yet! And just to prove the point he had Labour Minister Celestino Corbacho and Economy Minister Elena Salgado announce in short order that Spanish citizens are a) going to work two more years each in the

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ASIAN BAROMETER longer term, and b) will face continuing and sweeping cuts in services and increases in taxes in the short term. The trigger for this rather unexpected show of determination seems to have been the growing danger of contagion from debt crisis worries in Greece, as Spanish 10 year bond spreads briefly nudged through the psychological threshold of 100 base points above the comparable German benckmark. Spain's banks have extensive government bond holdings, and as the spread rises the market value of these bonds falls, so - given that another important part of the banks capital base is composed of land and property assets of uncertain value - the prospect of a slide in the value of the bonds they hold leaves Spain's government with little alternative but to be seen to be taking "serious" measures, whatever the cost. What's more, despite the positive impact on unit labour costs of all that unemployment, the impact on the social security fund means there will be a longer term cost for Spain's already badly challenged pension system. Quite how Spain's citizens will react to the news that their government's policy is now being driven by the need to "calm market fears", and that the country's leaders are actively considering asking them to retire at 67, still remains to be seen. Recent warning shots from political rivals and unions alike may leave their mark in the short term, but it is now clear that things have, in fact, changed, and Spain's politicians (and the bankers who influence them) are now likely to be much more sensitive to market sentiment than they are to public protest. And what could be nearer to the heart of market sentiment these days than the fiscal deficit numbers. "It's a plan that is essential after our most recent deficit figures," Finance Minister Elena Salgado told journalists when she announced her last batch of measures. The main problem facing the Spanish government now is credibility, and what to do about the impression that the national airplane is flying pilotless over that perilous nocontact zone. Certainly the impression that someone is really in charge took a further unwanted hit when Spain announced an annual deficit of 11.4% for 2009 after I think I saw an Anglo-Saxon conspirator there! previously (only two weeks earlier) saying the deficit was expected to come in at 9.5% of GDP. In fact it is rather surprising that as recently as last September (when the government first presented its budget plans for 2010) the deficit was still being forecast to come in as low as 5.2% of GDP (52 billion euros), while by November the forecast had already risen to 8.5% of GDP (85 billion euros) and finally (just two months later) we are told that it was 11.4% (over 110 billion euros). A number of questions automatatically arise, like just what level of control the Spanish government actually has over its deficit, and just how convincing is the government's plan to make a three year, 50 billion euro reduction in a deficit which has just shot up in four months by more or less exactly the same amount without anyone (officially) forseeing it! And Elena Salgado's still incomplete deficit reduction plans critically depend on economic growth

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"Spain's Public Works Minister José Blanco came out with the claim that country is

the currently victim not just to a strong speculative attack but also to an “Anglo-Saxon press” lead plot to destroy the euro" forecasts – which rise to about 3 per cent a year in 2012 – that many independent economists regard as totally unrealistic. Even the IMF, with whom Ms Salgado recently took issue, are not convinced by her numbers and forecast a 0.6% (and not a 0.3%) contraction this year. The government now projects a 1.8% gain in GDP in 2011, with growth in 2012 up as high as 2.9%, from a prior 2.7%. Of course, you can pull numbers (like rabbits) out of any hat you like, but that won't bring you growth, and certainly nothing like 3% growth in 2012. So we are heading towards trouble, even as the Brussels control tower seems to be having difficulty maintaining contact with the pilot and his crew. And time is running out. As Victor Mallet put it in the Financial Times - the recent austerity announcement does little answer the one question which is now uppermost in the minds of all those investors and economists who are busy worrying themselves about the future of Europe: can Spain control its budgets and once more become competitive within the constraints of the single European currency? Mr Zapatero insists it can, but he and Ms Salgado have yet to prove it. Let's hope they have an up to date set of charts to guide them.

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