A New Location for Notayesmanseconomics

As of Monday the 21 st of March new content on Notayesmanseconomics will be available at the new location shown below. There will be no change in the content, quality or independence of this blog and I hope that you will find the new format an improvement. The change will also ensure the long-term future of this blog and I hope that you will welcome that. 

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Can even concerted currency intervention by the G-7 work? And yet more signs of a weak UK housing market emerge

Just when you might think that it is time for something of a rest the flow of economic news has if anything accelerated further! After wondering yesterday where the Bank of Japan had been when the Yen surged to 77.18 against the US Dollar – and thank you to those who contacted me to suggest it had been suffering from a Tokyo power cut…- it finally gathered its thoughts and in line with its government asked for help from the G-7 group of nations and overnight they have announced this response.

at the request of the Japanese authorities, the authorities of the United States, the United Kingdom, Canada, and the European Central Bank will join with Japan, on March 18, 2011, in concerted intervention in exchange markets…… We will monitor exchange markets closely and will cooperate as appropriate.’

Once this was announced the Bank of Japan began to sell its own currency and buy the US dollar and market estimates are that it spent some US $3 billion in its first wave of currency intervention. The Yen rapidly weakened from 79.25 to around 81. As I type this article the Yen is now at 81.26 versus the US dollar which is down 3% in Yen terms on yesterday. Against the Euro it fell by around 4% to 115.3 although it has now retraced to 114.3.As the day develops we will expect to see the Bank of England and the European Central Bank act first followed later by the American and Canadian central banks.

Will it work?

In the short-term I believe that this intervention has a good chance of success. Although I would have preferred the Bank of Japan to have called for help and intervened when the surge in the Yen took place on Thursday morning Tokyo time when it reached around 76.25 (markets seem to have settled on this number now)  against the US dollar as it may have prevented the rise by so doing. I still am unsure why it did not do so as it was happy enough to intervene at a much worse level (83) back in September 2010. I do hope that the delay was not due to politician’s wanting to be involved and to in effect grandstand and feel important. Another factor which may help in the short-term is the fact that the G-7 group of nations has not intervened in this way since September 2007 and the fact that everybody can see that whilst there is potential for economic advantage for Japan in this the main motivation is a response to a severe natural (and with the nuclear reactors man-made) disaster.

In the longer-term the prospects are much less certain. If you analyse Japan’s economic situation it was already true pre-earthquake that there were more and more reasons for expecting the Yen to weaken over time. One US fund manager Kyle Bass believed in this story so much he took out a personal mortgage in Yen in order to benefit from its fall. However the truth has been that it has got stronger. Post crisis it is plain to see that there are more reasons to expect a weakening of the Yen. For example Japan will have to import more raw materials as she rebuilds and she will have to import more energy as the four troubled reactors will not be used again. In addition she will have to borrow more and this will add to already high levels of public borrowing which are around 220% of her economic output as measured by Gross Domestic Product. So yes the Yen should in the end weaken but the influence of the “carry trade” which I wrote about yesterday could yet lead to further Yen rallies as we simply do not know how much of this remains to be unwound. What we do know is an enormous amount of it appeared to take place.

Other Monetary Easing by the Bank of Japan

As well as its currency intervention the Bank of Japan has undertaken other measures which one might ordinarily expect to weaken the Yen. One clear example of this is its increase in the supply of money in Japan which has totalled some 37 trillion Yen (around US $450 billion although with such exchange rate volatility care is needed…) over the week of which some 3 trillion Yen was supplied last night. Conventional economic theory would suggest that an increase in money supply of this form is likely to lead to a fall in its price which could be via inflation or a fall in the exchange rate. However,in my opinion, caution is needed with such analysis as the velocity of money is likely to be falling maybe by as much or more as the increase in the money supply. Putting this into basic terms those in the earthquake zones are likely to hold more cash and the failure of one group of cash machines is likely to exacerbate such trends. I would imagine in this areas there is even some inflation as people bid for supplies of food and fuel which are in short supply. Inflation is rare in Japan but in its North-East I am sure it is present.

If it affected you

Imagine you were a foreign national working in Japan and for simplicity you are paid in US dollars. When the earthquake hit if you had just been paid you could exchange your money into Yen at 83 and if by some stroke of bad luck you were paid at the peak you would have got 76.25. This would mean you were around 8% poorer in less than a week! Please do not misunderstand me many in such a situation have more pressing concerns right now but the point still stands and it shows the impact of such economic volatility.

The Fukushima 50

I would just like to send my sympathies and admiration to the Fukushima 50. At a time of enormous personal risk these people are struggling to get the four troubled reactors under control and having read about the consequences and implications of what happened later to those who acted in similar fashion at Chernobyl they have my respect. For those who have been able to evacuate the area I think they owe them a bit more than respect and this is brought into focus by Japan announcing as I type that the disaster is now up to 5 on a scale which only goes to 7. Am I the only person who feels there is something Orwellian about measuring things in this way?

I have to confess that the efforts to attach what appears to be the equivalent of an extension cord to reactor number 2 on the site reminds me of an episode of South Park. There the world was in a panic over the end of the internet which was solved by a nine-year old boy walking up to it taking the plug out and putting it back in. Sadly we are unlikely to find anything like such an easy solution to this problem…..

Some perspective on the price of crude oil

I wrote earlier this week that I was surprised to see a fall in the price of crude oil. To my mind this was happening when there were two influences which in my opinion were likely to raise and not lower the price. These are the continuing crisis in North Africa and Arabia which are both oil-producing regions and the situation in Japan which will mean that as soon as things return to normality the world’s largest oil importer will need yet more oil to replace what was previously supplied by Fukushima nuclear reactors.

If we look at what happened the front month futures price of a barrel of Brent crude oil reached a low of US $107.35 on Wednesday. It started a surge on Thursday morning and rose by 4.15% on the day reaching US$ 114.9 as I was calculating some numbers last night. Now if we look back to see the potential inflationary impact of this we can see the following. In early 2009 the oil price was below US $50 and if we move forwards in time it was below US $80 in late September 2010 and started 2011 at US $95 per barrel. So overall we have seen quite a surge which will have inflationary implications. For example the price of a litre of diesel is now just under £1.40 at the garage around the corner from my home and the price of a litre of petrol is now just under £1.34. To the extent that people have fixed budgets the rise in the price of oil will have deflationary – as in a reduction in aggregate demand – impacts on the world economy too which reminds me of one of the themes I established for 2011.

Never Fear the FOMC is here!

I am reminded of the statement issued by the US central bank earlier this week and the emphasis is mine.

The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.

Phew! For a while I thought that we had real problems! More seriously they simply do not know this and British readers will be rather familiar with their central bank calling inflation “temporary” and “one-off” and again in the British case of the central bank proving to be a reverse indicator of inflationary trends as well as an abuser of definitions in the Oxford English Dictionary.

The UK Housing Market

I have written on several occasions that I feel that 2011 looks like it will be a difficult year for the UK housing market and that due to a technical move by the Bank of England a fall in house prices could become something of a rout. I see that weak mortgage lending figures for January have been followed by equally weak figures for February where gross mortgage lending was only £9.5 billion. No doubt the same excuses being used in January will be wheeled out but here are my thoughts from the 28th of January.

I wrote an article elsewhere back in December about the Bank of England’s withdrawal of its Special Liquidity Scheme and the impact I feel that withdrawal around £9 billion per month is likely to have on the availability of credit in 2011 and in particular on mortgage finance. I feel more and more that this move was and is a policy error.

I see nothing in the news that has emerged since I first wrote on this topic back in December 2010 to make me change my mind, in fact the news since then only confirms what I predicted.  I would be interested to see what evidence readers have from their own area on the state of the UK housing market.

Why did the Japanese Yen surge last night? And more misrepresentation is exposed in Ireland

Last night saw some extraordinary moves in financial markets. In terms of underlying news the situation in Japan and in particular her nuclear reactors at Fukushima Daiichi  continued to show signs of deterioration. As I wrote yesterday I feel that if you consider Japanese culture and how they behave the fact that the Emperor spoke publicly was very significant and I am afraid also rather ominous. Just to add to the bad news the forces of Colonel Gaddafi declared that  civilians should leave Benghazi at ten pm UK time if they were near any rebel forces. And the situation in Bahrain continues to show signs of increasing rebellion followed by stricter crackdowns. In the middle of all this the Japanese Yen shot higher on foreign exchanges and the Japanese Nikkei 225 equity index was called one thousand points lower with a couple of hours to go before its opening. The Nikkei 225 in fact opened some 300 or so points lower but recovered somewhat and closed 131 points lower at 8962.

What happened to the Yen versus the US dollar?

At first we saw what at the time seemed quite a significant event as the Yen strengthened and went through its 1995 high of 79.78 against the US dollar as it pushed through the 80 level initially to the mid 79s. In itself, an all-time high versus the US dollar is significant enough as if you look at my category for Japan’s economic crisis on this blog you will see that I often discuss how Japan’s rallying Yen has made life more and more difficult for Japan’s exporting industries and even lead to a monthly trade deficit recently. However then in a fevered atmosphere the Yen shot higher passing through 79 and then 78 before peaking at 77.18. The atmosphere was so fevered that I am using figures from the Financial Times as others are claiming that in fact 76.25 traded! I suspect that may be what is called a high-tick (where someone deliberately pays too much for something to get that price to trade…).

This morning the situation has calmed down with the Yen exchange rate falling back into the 79s for a while. However as I type this I notice that it has dropped again and is now at 78.96. If last night had not happened this would be seen as a very significant move and it would be an all-time high. The Yen also rose strongly against other currencies and I will return to the significance of this in a moment.

Why is this particularly significant? The carry trade

Back in the middle of the last decade there was a period where “the carry trade” was very significant and let me quote from my article on the 24th of December 2010 explaining what it is.

One of the factors that has led to the distress of recent years has been the carry trade. For those that are unfamiliar with it let me give an example of how it works. If you do it the interest-rate in your own currency will be higher than the interest-rate of the currency you intend to borrow. For example the countries whose currency was most borrowed for this purpose Japan and Switzerland had low interest-rates in the middle of the last decade whereas many parts of Eastern Europe had high single figure interest-rates. Accordingly each year there is an interest-rate or carry profit and in some cases this was fairly substantial.

The numbers quoted there refer mostly to the Swiss Franc carry trade so I have looked up some data for Japan. If we go back to 2005 the official Japanese interest-rate did not rise above 0.1% and it has not been above 0.5% for quite some time. Now if we look at official interest-rates in Australia between 2004 and 2006 they were either 5.25% or 5.5% before rising over time to a peak of 7.25% in early 2008. As you can see there is quite an interest-rate saving in borrowing in Japanese Yen rather than Australian dollars. So investors did and they did so on a very large-scale and Australia is only an example there were many others to whom this applied. Even for a trading nation the size of Japan the enormous size of currency investments based on this carry trade dwarfed her economy,trade flows and currency.

This requires a little bit of mental dexterity but if others borrow in your currency then it is depressed (it is the reverse of them buying it…). So the carry trade drove the Yen and the Swiss Franc lower and if you think about it this will have encouraged more investors to do this trade as not only did it have annual interest-rate gains but it started to look like there were capital gains to be had too. If it seems to good to be true then you are getting the picture but for a while this did work rather well. Those who really profited from this would have been those who remember the financial market aphorism “there are the quick and there are the dead”.

How did the Carry Trade go wrong?

As I have just pointed out it became too popular and swamped the Japanese economy/currency let alone the much smaller Swiss economy/currency.The obvious problem is that as ever more were attracted to the scheme the problem of an exit strategy got worse. How could this ever be reversed without having the effect of raising the value of the Swiss Franc and Japanese Yen ? The answer is that it could not and in fact has been taking place recently when the Swiss Franc and Japanese yen have been strong due to theirs safe haven status (I know with the earthquake and tsunami this is an irony for Japan).The error was the size of the trade which was much too large for the size of the Japanese Yen exchange rate market let alone the Swiss Franc.

I am sure that some were encouraged to borrow more as monthly repayments under such a scheme would be much lower than before. If you think of a mortgage affordability calculation under the new lower interest-rates the possible implications become plain.

There are considerable implications for the countries whose exchange-rate has been borrowed and the smaller the economy the more likely it is that it will be swamped. They find that their currency is artificially depreciated at one phase of the arrangement and later artificially appreciated at the final stages.

So where are we now?

If we concentrate on Japan we can see that her currency appreciation in 2010 and 2011 was probably driven by some investors unwinding their carry trades as they spotted that world events were making the Yen stronger. As you can see this is something of a self-fulfilling arrangement and it pretty much describes why the Yen has been so strong. Now we have another factor which is that Japan has very large savings abroad and with her obvious need for reconstruction foreign exchange markets feel that she is likely to repatriate money to help with this.This is what she did after the Kobe earthquake in 1995. As an example of the sums involved Japan’s government is estimated to have just under US $ 900 billion in US Treasury Bonds.

There is a debate going on right now as to whether Japan actually is repatriating funds or not but I consider this to be rather academic as the real issue is whether markets think she might. As it happens the Yen is often strong at this time of year as Japanese companies tend to repatriate funds ahead of the end of their financial year. However some parts of the media try to spin the story a strengthening Japanese Yen is not good for Japan right now and those suggesting that it will help against inflation appear to be unaware that Japan has not got any!

Why has the Bank of Japan not intervened to weaken the Japanese Yen?

If you have been wondering this then so am I! Put another way I am not a fan of exchange-rate intervention as I have argued before and I wrote this back on the 15th of September 2010 when the Bank of Japan intervened at 83 to the US dollar.

Whilst the intervention has had a short-term success we are so far only measuring its impact in hours. Over time I expect the foreign currency markets to challenge the willingness of the Bank of Japan to weaken its own currency.

Pre-earthquake this is pretty much what has gone on with the Yen ebbing and flowing but not weakening as the Bank of Japan would have hoped. Now with the earthquake,tsunami and reactor problems the Yen has surged again. Let me be clear the Bank of Japan cannot be expected to have known about them but in my view this natural disaster does again show us how central banks have over-extended themselves and become vulnerable to “expect the unexpected” events. Yet oddly at a moment when intervention might have had a success the Bank of Japan was nowhere to be seen. Short-term movements caused by a natural disaster are one of the situations where foreign exchange intervention can help in my view and are a valid policy option. Indeed if I was in charge of a foreign central bank I would intervene and help too and concerted intervention is the most likely to have an effect.

Psychology and markets

This is difficult to measure as we are into opinion and looking into the human sub-conscious. However the fact that the Yen has risen to nearly 77 against the US dollar tends to set a new trading range in the human mind and we have a new landscape which before last night was not there. Put another way the spilt wine is out of the bottle. For those who look at this as a chart and do technical analysis we are into uncharted territory (sorry) and accordingly some forecasts now will be of a further substantial rise.

The Swiss Franc

I wrote an article back on the describing the Swiss Franc and Japanese Yen as “currency twins” because if you look back in time their behaviour has been similar. Whilst today’s article has concentrated on Japan I wish to point out that the Swiss Franc has been strong again too and is currently at 1.26 verus the Euro. The 1.7 million Hungarians who have a mortgage denominated in Swiss Francs will see their mortgage rising again as the Swiss Franc hits 219 dinars.

Ireland

I wrote a month or two ago that the Chairman of Anglo-Irish Bank had reported that he felt that the 35 billion Euros set aside in the EU/ECB/IMF rescue plan would not be enough and more would be needed . This was officially denied and the official view was that only  10 billion would be required and that the reserve of 25 billion would not need to be touched. Now I notice that the new government is weakening on its predecessors position and I expect a much higher figure to emerge. The new Finance Minister Michael Noonan has openly said that he feels that 10 billion Euro’s will not be enough.

So Ireland’s previous administration will go into the history books with one more example of it misrepresenting the truth  and we have an explanation of why Ireland’s ten-year government bond yield is at 9.76% i.e higher after the “rescue” rather than lower.

The implications of the new (flawed as usual) bailout plan from the Euro Zone for Portugal Ireland and Greece

After covering Japan in-depth so far this week I intend to move onto other economic  matters today. Before I do there are some matters to touch on.Looking at the markets Japanese shares have staged something of a recovery overnight with the Nikkei 225 equity index rising over 5% to 9093. However I have to confess concern at two things. Firstly that the Japanese Emperor spoke to his people and secondly that he said that he was “deeply worried”. If you look at Japanese culture that has an ominous tinge to it. Things may have changed a little since the end of the Second World War but the Emperor then managed to avoid saying that they had lost! As Japanese Emperor’s speak very rarely this news makes me concerned that there may be more bad news to come from the four stricken nuclear reactors.

Japan and a problem with how we measure economic growth

The Japanese situation illustrates a clear problem with how economic growth is measured. Ordinarily we use estimates of Gross Domestic Product (GDP) but it does have flaws. Consider this. We have seen a lot of destruction in Japan due to the earthquake and tsunami but this is not recorded as a loss of economic output whereas when such buildings are replaced we see a positive contribution to economic growth as measured by GDP. If you are currently homeless until a new one is built you may wonder as to why there is no measure of your loss and to my mind you would be right. I doubt if anybody will ask if you prefer the new home.

My suggestion would be that for the purposes of measuring economic output we should also have a measure for improvements in the national stock of wealth. For example a new modern building may well be better than the one it replaced and we should try to measure this. Otherwise we run the danger of any destructive national disaster leading to an increase in GDP growth when reconstruction begins without allowing for the losses which take place. For countries unaffected by the disaster the situation is simpler as if they produce something it increases their GDP but for the country affected we need to develop a measure of the loss in my view. Otherwise our estimates for GDP will diverge from the true economic situation and the bias is always likely to be upwards.

The Euro Zone’s new policy for the peripheral nations

Over the weekend Euro zone ministers and officials met to discuss what they can do about the problems afflicting the peripheral nations of Portugal, Ireland and Greece and which looked like they might spread further to say Spain and Italy. Let us look at what they came up with. By ESM they mean European Stability Mechanism and by EFSF they mean European Financial Stability Facility.

The ESM will have an overall effective lending capacity of 500 billion euros. During the transition from EFSF to ESM, the consolidated lending capacity will not exceed this…………. Until the entry into force of the ESM, the agreed lending capacity of 440 billions euros of the EFSF will be made fully effective.

This addresses in theory the main problem of the EFSF which is that whilst it has a theoretical capacity of 440 billion euros because of incompetence in its design it can lend in reality only up to 250 billion Euros. However you may note that there is no description of how they are going to increase its size! We have been told this many times before and it has not happened so readers may be forgiven for an attack of deja vu. Also when the ESM replaces the EFSF in mid-2013 it is going to be larger. This rather contradicts the official view which to quote D Ream is that “Things can only get better” does it not? If so why do they need a larger rescue fund? Also the ESM will require individual nations to raise some of its capital er Greece, Ireland Spain……

However, to maximize the cost efficiency of their support, the ESM and the EFSF may also, as an exception, intervene in the debt primary market in the context of a programme with strict conditionality.

This has led to something of a stir as it suggests that these instruments could for example take up a bond issue or issue from a country in trouble. This is different from the Securities Markets Programme of the European Central Bank which only buys in secondary markets ( However the SMP has recently operated at the same time as debt issues in Portugal which blurs the line a little). However I do not feel we will see debt issues from say Greece taken up by these mechanisms yet as there are many checks and balances in the system as otherwise such purchases would go straight to the German Constitutional Court. Should it begin to operate this is one of the steps towards fiscal union which is probably the real reason it has been proposed. Rather than for use now it is intended for later use in response to a further crisis. Somewhat sneaky I think.

Pricing of the EFSF should be lowered to better take into account debt sustainability of the recipient countries, while remaining above the funding costs of the facility, with an adequate mark up for risk, and in line with the IMF pricing principles. The same principles will apply to the ESM.

Finally a genuinely good idea although yet again the German Constitutional Court is hovering in the wings. It may yet rule such assistance as being illegal.

Some better news for Greece

Against this background and in view of the commitments undertaken by Greece in the context of its adjustment programme, the interest rate on its loans will be adjusted by 100 basis points. Moreover, the maturity for all the programme loans to Greece will be increased to 7.5 years, in line with the IMF.

Essentially in return for promising to continue with its austerity programme and intending to make some 50 billion Euro’s of privatisations Greece gets a cut in the interest-rate applied to it from 5.23% to 4.23% which is good news for her. Also the period of her loans gets extended too. Whilst these are both helpful moves they remind us of the confusion at the heart of Euro Zone policy. When the ” rescue” for Ireland was instituted we were told that Greece’s loans were going to be  at 5.8% and for ten years which was an extension of 7 years and a rise in interest -rate of around half a percent. Now they are at 4.23% and are for 7.5 years. No wonder markets have lost faith many may be wondering what the next interest-rate and term will be! It would appear that the concept of planning for the long-term is alien to Euro Zone politicians and officials.

Why not Ireland too?

This is rather simple. Greece had to give up her objection to more privatisations in return for a cut in interest-rates and regular readers may remember the dispute on this point a few weeks ago. But Ireland has stood firm on the issue of raising her Corporation Tax rate which is currently the quid pro quo of a cut in the interest-rate on her bailout package.

Comment

The reduction in the interest-rate for Greece is welcome although I wonder how many time s the Euro Zone will announce it has extended its loans to her! Most of the other changes have a heavy element of deja vu and ennui as we have seen them before. But there is a proposed move towards fiscal union with the concept of the EFSF and the ESM potentially purchasing primary government bond issues. This brings the idea of a joint “Eurobond” nearer. It is plain to me that such a Eurobond would need many conditions and with the Euro zones record of sticking to conditions the words of Charlie Brown’s dog Snoopy come to mind “Good luck with that (with the implication that you are going to need it!)”

Portugal is downgraded by Moodys ratings agency

Moody’s Investors Service has today downgraded Portugal’s long-term government bond ratings to A3 from A1 and assigned a negative outlook.

Not entirely as auspicious welcome for the new improved Euro zone support package (which implicitly stands behind Portugal) is it? If we put to one side the fact that the three main ratings agencies as a minimum need major reform let us look at the detail of why Moodys have done this. From the Financial Times we get.

1. Subdued growth prospects and productivity gains over the near to medium term until structural reforms, especially in the labor market and the justice system, begin to bear fruit;

2. Implementation risks for the government’s ambitious fiscal consolidation targets;

3. The government’s balance sheet may need to expand further in the event it has to provide financial support to the banking sector and government-related institutions (GRIs), which are currently unable to access capital markets; and

4. Challenging market conditions that have led to increases in the government’s financing costs, which, if sustained, will cause its debt affordability to weaken, particularly in the context of generally higher European interest rates.

Comment

The essential problem at the root of this is a lack of economic competitiveness in Portugal which has led over time to slow economic growth and consistent and somewhat chronic balance of payments deficits. I have put on here several times a chart which shows how slow Portuguese economic growth has been relative to the rest of Europe since 1990 so the problem way predates the credit crunch. Also Portugal has had to call in the International Monetary Fund before to help with balance of payments problems. Accordingly her issues are quite different to Ireland and Greece.

The Portuguese government may feel hard done by after announcing a new range of austerity measures last Friday which mean that she now plans to reduce her fiscal deficit to 4.6% of GDP in 2011 and make further reductions in 2012 and 2013. So in 2011 the pace of austerity is now expected to accelerate which has downward implications for expected economic growth. Portugal now also expects to hit the Euro zone target of a fiscal deficit of 3% of GDP. In total the additional deficit-cutting measures are equal to 4.5 % of GDP over the three years up to and including 2013.This is, of course the flaw in continually asking for more austerity as I explained with the example of Latvia a year ago and that is the danger of a downward spiral before you (hopefully) improve. You need a plan for economic growth too.

Portugal’s opposition oppose the new austerity plan so the brief political consensus has broken and today just to add to her problems she has one billion Euros of twelve month bills to issue. In a way the fact that she is issuing twelve month bills rather tha longer-dated paper highlights her problems and reminds us that yes in a year’s time they too will have to be refinanced in a bond market example of having to run ever faster just to stand still!

The Price of Oil

I understand that recent rises in the price of oil left the price somewhat inflated but am I the only person wondering why it has setback? For example there are continuing problems in North Africa and Arabia as well as Japan which will have to increase oil imports to replace much of her nuclear output.

The effect of the earthquake in Japan on her equity and financial markets and some policy advice for the Bank of Japan

I do not often discuss the same subject two days in a row and even more rarely three but the ever worsening situation in Japan is an extreme event. Or at least we hope it is an extreme event! Again my sympathies go to them in their time of need. As to what has happened there was an explosion at the number 2 reactor of the troubled Fukushima Daiichi  site (the third such explosion at this installation)  and in addition there now is a fire at the number 4 reactor. Just to add to the tale of woe the official Japanese news agency is reporting that one of the pressure vessels of the reactors on this site is damaged. Radiation levels are rising quickly at the site and there are now reports that radiation levels are twenty times higher than normal in Tokyo itself with the only good part of this news being that radiation levels in Tokyo are usually quite low due to the geology there.

The Official Response: The Bank of Japan

It was only on Monday that the Bank of Japan responded to the crisis by adding 15 trillion Yen ( US $183 billion) of liquidity to calm money markets and to try to make sure that cash would not run out in Japan with the priority being the troubled North-East of Japan. In addition it doubled the size of its asset purchase programme from 5 trillion Yen to ten trillion Yen or US $122 billion . Some news agencies are saying that the total is now 40 billion for asset purchases but this (incorrectly in my view) includes 30 trillion Yen of loans.

The Bank of Japan responded to the deepening of the crisis today by adding a further 8 billion Yen (US $98 billion) of liquidity to the system as it struggles to deal with the consequences of this natural disaster for Japan’s money supply and monetary system.

Comment

I see that the Bank of Japan is coming under criticism for not doing more than it already is. If we look at what it is doing this is one of the circumstances when the response of a central bank to a request for cash is simply “how much do you want?”. In previous articles I have discussed this in relation to banking crises and a natural disaster is the same. This is what the Bank of Japan is doing.

Furthermore this is also a situation where, in my opinion, exchange-rate intervention can be effective. This is because it would be responding to a (hopefully) relatively short-term movement in the currency. This is a proper use of foreign exchange reserves as it can be unwound relatively easily after the crisis has passed. This is quite different to standing in the way of a long-term foreign currency trend in the way that both the Bank of Japan and the Swiss National Bank did in 2010 which had little effect and only  accumulated losses which were large in the case of the SNB. So the Bank of Japan should stand ready to intervene if necessary and as I often point out with Japan she is likely to be intervening against currency strength rather than weakness. I have my own thoughts as to what may happen to the Yen as a longer-term effect of this but for now the natural tendency for the Japanese to repatriate savings from abroad has seen the Yen strengthen during this crisis.

Quantitative Easing in Japan

Quite different in my view are the calls for both an acceleration of and an expansion in the level of asset purchases planned by the Bank of Japan which is also known as Quantitative Easing. These are by no means a fine-tuning operation and even supporters of such a policy are likely to feel that a period of thought and reflection is required before any such programme is started. If nothing else how can anybody be sure what would be the right amount at a time of such great uncertainty? We plainly do not know. Also Japan has tried QE several times during the economic problems she has faced since the Nikkei collapsed in 1990 and we must remember that in spite of such programmes the “lost decade” has extended for 20 years  now.

I am afraid that some of the supporters of such a programme do themselves no credit at all because what they actually appear to be asking for is a version of what has variously been called the Greenspan put option or more latterly the Bernanke put option. This strategy is where equity investors believe that they will never have to take large losses because the relevant central bank will take measures to always bail them out. As an example of this I see that the Vampire Squid ( Goldman Sachs) has called for such action today and at the same time my memory points out that they recently went bullish on the Nikkei and gave recommendation to buy it at around the 10,500 level. In my view bailing out equity investors is not one of the roles of a central bank as at a time of crisis like this it has more important things to do.

The Market Response

I watched the opening of the Japanese equity market (midnight UK time) and both the Nikkei 225 and Topix equity index were quickly down by around 4%. This was significant as because of the way that prices and volumes are matched Japanese markets can react more slowly in the short-term than western ones. As the news from the stricken reactors deteriorated the Nikkei collapsed to 8228 at one point in what was a panicked and fevered atmosphere before recovering to close only (?) 1015 points lower at 8605.

I have seen many views advanced on what may happen to the Yen but if we look at its moves versus the US dollar we see a rally in it from around 83 pre-disaster to 81.4 now. Knowing the Japanese as I do they are likely to be repatriating funds to help with the crisis and this combined with some currency investors anticipating this seems ample explanation for the rise. Looking further forward once the repatriation of funds ends it is not impossible that we may have finally found an event which halts and maybe even reverses the rise in the Yen. As discussed in the comments section yesterday if nothing else Japan is likely to have to import even more fuel to replace the power that was provided by the stricken reactors. This will have to be paid for….

World Markets

European equity markets are being hit hard this morning as the possible consequences of the radiation leaks are considered.  The UK FTSE 100 is down nearly 3% as I type this and the German Dax index has fallen by over 300 points or nearly 5%. Should the situation remain the same in Japan then America’s equity markets are likely to be affected in a similar fashion.

Government Bond Markets rally

These tend to rally at times like this and accordingly we are seeing a reversal of the trend that has been in place for the last 6 months or so. World economic fundamentals get swamped by the crisis effects of a “flight to quality” or safety and the fact that world economic growth is now likely to be lower than previously thought. If we use the ten-year US Treasury Bond as a world benchmark we can see that yields which were testing the 3.6% level at the peak are now at 3.37% which means there will have been a decent rally in price terms.

In the UK our equivalent ten-year yield had gone above 3.8% but has now fallen to 3.63% as similar effects take place. Rather ironically it does provide a favourable backdrop to the Euro zone deal which was announced at the weekend! In a favourable accident of timing they have events in their favour for once so it may take slighty longer than normal for the flaws in their plan to be spotted.

Overall Comment

I am reminded at a time like this of the power of nature and the relative weakness of man. If we put such thoughts into the economic sphere I would like to look at again the theme that I have developed which is of central banks interfering ever more in world affairs. Apart from the problems I have suggested with this philosophy before we have yet a new example of “the unexpected” damaging their plans. I hope that they will realise that it is their philosophy which is wrong rather than try to intervene even more.

Also I would like to thank everyone for the quality of their comments which is a strength of this blog. Also I do have updates ready on other issues such as the Euro zone plan but right now all eyes are on the most significant event which is/are the developments in Japan.

The news media has had various forecasts over the last 48 hours of the scale of the crisis and many of these also try to tell us the scale of this catastrophe and come with a promise of a recovery which is fast. I will leave you with one thought, exactly how do they know that?

What will the effect of the Earthquake and Tsunami be on the Japanese economy and the rest of the world?

Firstly let me repeat my message of Friday wishing the Japanese people well in what are very difficult times with many dead and injured. Perhaps the biggest hindrance to a full rescue effort is the fact that 3 nuclear reactors appear to be running wild with their engineers struggling to try to bring them back under control. As Japan’s buildings appear to been built to withstand earthquakes and in general have survived well we get lesson one from this crisis which is that even the most advanced nations should think twice in future before building nuclear reactors in earthquake zones. We of course do not yet know how badly this particular facet of the crisis will play out but in culture where the word for yes hei (hai)  can mean both yes and yes maybe and the underlying importance of loss of face means that the Japanese authorities are very unlikely to be telling us the truth about the real situation.

For the full impact of this crisis and to analyse how it is likely to play out we need to consider the underlying state of the Japanese economy. 

The Main features of the Japanese economy

1. One issue for Japan has been that whilst it has been a success as a net exporter it has also often suffered from insufficient domestic demand. For UK readers it is in some senses a doppelgänger of us! (although we export more than we think as it is swamped by our even higher imports). Various measures have been tried to solve this but the problem has persisted.  I wrote an article over a year ago on this subject and if we look at the data for November 2009 in Japan one can see examples of this. On a month on month basis industrial production rose by 2.6% but retail sales fell by 1.0%.

2. The next Japanese problem is disinflation or negative inflation, and yes I do mean that prices are actually falling and they have been falling for quite some time. The main Consumer Price Index (CPI) for Japan was rebased at 100 back in 2005 and in January of this year it was at 99.4. Yes some 6 years later prices were lower overall than they were in 2005! The monthly change was -0.2% which reinforces the message. The highest level this index reached was 102.7 in August 2007 and so it has spent 33 months lower than this peak. there has been the occasional slight uptick but in general the trend has been for falling prices.

3. The next problem is the size of Japan’s national debt.  The severe recession and sizeable fiscal stimulus  pushed up Japan’s public debt from 188 percent of GDP in 2007 to 218 percent of GDP in 2009. The International Monetary Fund has published reports saying that it feels the ratio could reach 250% in 2014. These are extraordinary numbers and are only possible because the Japanese purchase approximately 95% of their own government’s debt. Accordingly a loss of faith by overseas investors would have only a minor impact.

4. In spite of her incredibly large national debt Japan has run large fiscal deficits in recent years. For example according to the latest IMF Fiscal Monitor she ran a fiscal deficit of 10.2% in 2009 and 9.6% in 2010 and expected a deficit of around 9% this year but this was pre-earthquake. So deficits are high and showing few signs of falling by much.

To try to solve the problem the Japanese government has announced a record annual budget of 92,410 billion Yen ($1,100 billion, £689 billion) for the fiscal year which begins in April 2011. The government came into power promising to give more money to Japanese households and as time developed promised to cut the fiscal deficit. However as circumstances have evolved they have quite a few problems.

a. Japanese tax revenues for 2011 are expected to be  around 41,000 billion Yen

b. Japanese government bond issuance is likely to be 44,300 billion Yen.

These numbers have serious implications. Tax revenues have fallen so far that they are back down to mid-1980s levels and now in both 2010 and 2011 bond issuance will exceed tax revenue which are the only times since the Second World War that such an event will occur. 

5. There is also the problem of   Japan’s ageing population.With long-term solvency an increasing problem for Japan as a nation then its ageing population structure makes the potential problem worse. Its population is 130,000,000 but its birthrate per woman has dropped to around 1.3. Demographers estimate that a level of 2.07 is necessary to maintain a stable population.Combining this with the fact that people are living longer then the Japanese working population will have to support more older people as this century progresses. This is not a good mix.

The Impact of the Earthquake and Tsunami

There have plainly been influences on Japan’s agriculture, industry and power supply.Paddy fields that have been contaminated by sea water are unlikely to produce any rice crop at all this year and it remains to be seen how much of Japan’s rice output will be affected. Many industries will remain closed on Monday and we will have to wait and see when they reopen. The production of Japan’s power industry will be affected by the problems of her nuclear reactors several of which are likely to be switched off for the long-term.Rather ironically some of them may be pouring out power at this time.

If we look at Japan’s economic output it is bound to be affected by this and as she just had a quarter of negative growth it is quite possible that she could have another recession which would require another quarter of negative economic growth. Many industries may be affected by the power cuts and blackouts which look likely to continue for at least a while. Apart from anything else this will do her national debt and  fiscal deficit problems no good at all.

The Policy Response

Bank of Japan

One move that is not available to the Bank of Japan is a cut in interest-rates. The reason for this is that they are already at 0.1%, so there is no room for a cut of any significance. The most appropriate move it can make is simply to supply cash and it started to do this on Friday in its role as a “lender of last resort”. It provided some 55 billion Yen ($670 million) of cash to institutions in the worst hit areas. In addition the Governor of the Bank of Japan promised this according to Reuters.

We will monitor market conditions and plan to provide markets with a lot of liquidity first thing tomorrow morning.

It is likely that the Bank of Japan will offer around 7 trillion Yen to stabilise money markets.

Also the Bank of Japan may consider intervening should the Yen exchange rate weaken substantially. However let us not forget that for quite some time it has been trying to weaken the Yen! Accordingly it may even welcome a fall in the Yen exchange rate particularly against the US dollar.

In the short-term in a surprising occurence we are seeing quite considerable Yen strength with it rising to 81.4 versus the dollar compared to around 83 before the earthquake. So either Japan is repatriating funds – it has large overseas investments- or investors are anticipating this and “front-running” it. As time progresses I find it very hard to see how this can be sustained.

Quantitative Easing

Japan has had several goes at Quantitative Easing or QE in its attempts to deal with its “lost decade” which has now stretched for 20 years. The latest variant of this has the Bank of Japan spending some 5 trillion Yen or around US $62 billion. It is possible that this programme will be increased today with expectations stretching as high as it being doubled although frankly I fail to see how it can help much. Japan’s interest-rates are pretty much the lowest in the world all along her maturity spectrum.

Fiscal Policy

This is a big problem there is a contingency reserve in Japan’s budget but even some 200 billion Yen or US 2.4 billion is unlikely to go far. Japan will have some hard choices to make on this front as the situation develops as one would expect tax revenue to fall and public spending to rise exacerbating her fiscal problems. However in the short-term her government has little choice but to spend.

Comment

Not only is Japan’s economic output something that will be adversely affected in the short-term but reconstruction efforts which may help to recover this are going to be very expensive and will lead to further fiscal problems. Another obvious problem in the short and medium term is an energy crisis as nuclear power will be initially restricted and going forwards it is unlikely to be very popular to say the least.

Implications for the rest of the world

The first implication is on energy and oil I feel as Japan will have to increase her demand for these. If there is a substantial impact on her rice crop then she will have to import more food and so we may see more upward inflationary pressures on food prices. Rather ironically rice has been one of the slower movers in the recent rises. When the rebuilding effort really starts then there will be substantial demand for such materials as steel and aluminium.

It will be very expensive for insurers and now we can see that it will be a lot more expensive than was expected on Friday and so we will probably see their share prices fall again.

Nuclear power is likely to see a sustained drop in popularity even in areas which are not in earthquake zones.

Market Response

In the early part of trading Japan’s Nikkei 225 equity index has fallen by 5%. However care is needed with such numbers as Japan’s markets match quantities and not prices they are not the same as western ones. This means that as I type this some 30 minutes into the trading day many of the main shares have not traded at all with there being not enough buyers to match with the sellers.

Update 1:30 pm UK time

There have been some developments since I wrote this article. The Bank of Japan continued to add liquidity throughout the day and the total amount stretched to 15 trillion Yen. It also added to its asset purchase programme which now totals some ten trillion Yen.So this programme has in effect been doubled in response to this disaster.

I remain of the view that adding liquidity is a wise and proper move for a central bank in response to a natural disaster but still fail to see how more QE will help. However it would appear that some parts of the the Japanese banking system may come under strain (again) with banks in the affected North East of Japan apparently involved in earthquake insurance.

The Nikkei 225 equity index closed down around 6% at 9620. Since then there has been more bad news about explosions and leaks at Japan’s nuclear power stations and futures markets have fallen another 3% or so. Please remember that because of the relationship between interest-rates and dividends at this time futures prices will be below cash ones….

Expect the unexpected

Those who remember the recent discussion on here on this subject which put more formally I was taught as the “serially uncorrelated error term” will have food for thought this morning. Reactors built in the 1970s are being affected by what we are told is a one in a thousand year event. However in practice this event took less than 40 years! If the reactors had lasted a thousand years how many such events would occur?

UK Producer Price and Manufacturing output figures show that the Bank of England was wrong not to have raised interest-rates yesterday

Firstly today let me offer my sympathies to those affected by the earthquake and tsunami which hit Northern Japan this morning. The phrase “Ring of Fire” for some of the Pacific seems particularly appropriate recently does it not? From a personal point of view I did wonder about the implications of working on the 22nd floor when I worked in the Ark Mori building in Tokyo!  In terms of implications for her financial markets it is hard to say much about the 179 point fall in the Nikkei 225 equity index to 10,254. The reason for this is that the American Dow Jones Industrial Average had closed down 228  at 11,984 so the Nikkei may well have fallen by this sort of amount pre the influence of the earthquake.

The Implications of the latest figures for Chinese inflation and output growth

In addition to a natural disaster we got some significant economic news from the Far East this morning. From the Chinese statistics bureau we received this.

In January 2011, consumer price index rose by 4.9 percent over the same period of the previous year………The price of foodstuff increased 10.3 percent year-on-year……

In January 2011, Producer Price Index (PPI) for manufactured goods was up by 0.9 percent month-on-month and 6.6 percent year-on-year; purchasing prices for industrial producers rose by 1.2 percent month-on-month and 9.7 percent year-on-year. 

Industrial Production:In the first two months of 2011, the total value added of the industrial enterprises above designated size was up 14.1 percent year-on-year, or 0.6 percentage point higher than that in December 2010.

Is China still overheating?

If you look at the figures quoted above the answer still looks like yes in spite of the measures applied by the People’s Bank of China with its increases in interest-rates and banks reserve requirements. It is important to point out,however that many of these moves were recent and will take time to have an impact. Whilst consumer price inflation was the same in February as January there had been hopes it would fall back which were dashed by these figures. Sticking with the inflation theme it is plain from the producer price inflation figures that there is still considerable inflationary pressure towards the beginning of the price chain. I added the figures for foodstuff inflation to show that in addition to her own inflation problems China is also being affected by wider trends which are evident elsewhere.

If we look at the industrial production figures they almost define overheating do they not? Year on year growth of 14% is fierce enough before we factor in that this comes up top of previous high growth rates. Accordingly here too we see that more inflationary pressure looks likely as we go forwards from this source. This leads to the fundamental question will China over-tighten monetary policy in response? To which comes the answer it looks like so far she may have not done enough.

Further problems in the Euro zone

Whilst the next main meeting of Euro zone ministers is not until the 24th of March Euro zone politicians are meeting today and we may get some more news on their plans (assuming they have some!). The usual course is for all sorts of plans to be promised plenty of hyperbole and then some combination of unrealistic expectations and dissent shooting it down! I notice that the German Chancellor Angela Merkel has said that there could be “moderate reductions” in the interest-rates on the “rescue” for Greece and Ireland. So far so good until you here that in return Ireland will have to give up her lower corporation tax rate and Greece will have to sell off some of its state assets. Seeing as the last suggestion out of a German parliamentarian about selling Greek assets which referred to some of her islands was about as well received as Arsenal manager Arsene Wenger received the sending of Robin Van Persie on Tuesday night the prognosis is not optimistic! I was asked a while ago about the impact of the recent Hamburg elections where Chancellor Merkel’s party did badly and I feel that this is it, she is hemmed in by the need to appeal to her electors. Whatever you think of the policy that results it is at least a function of democracy something the EU often lacks.

More reasons why the Bank of England was wrong not to raise interest-rates yesterday

Regular readers will be aware that I have argued since I started this blog back in November 2009 (which seems like yesterday!) I have consistently argued that the UK economy needed and needs an increase in interest-rates to help ward off the inflationary pressure that looked as if it was on the horizon. That is my first message on this subject, in my opinion when setting monetary policy you find yourself having to look forwards some 18 to 24 months because that is the period over which whatever policies you implement usually take to have a full impact. It is also my first criticism of the Bank of England as its forecasting has been appalling and accordingly policy based on an incorrect forecast is likely to be incorrect too. Just to give one example of this (and there have been many) according to the February 2010 Inflation Report then Consumer Price Inflation should be just below 1% right now. It is in fact 4% which means that rather than being 1% below target it is in fact 2% over.

So we now find ourselves in a position where inflationary pressure is increasingly looking like it is inbuilt in our economy. Let us now look at the most recent data.

Manufacturing and Industrial Output in the UK

From the Office for National Statistics (ONS)

Year on year, overall (industrial)  production output in January 2011 was 4.4 per cent higher than in January 2010. (This was in spite of the fact that)  Output in the mining and quarrying sector decreased by 4.8 per cent in January 2011.

Total manufacturing output increased by 6.8 per cent in January 2011 compared to the same month a year ago…..Between December and January, manufacturing output increased by 1.0 per cent.

For those interested in the detail the strongest components of the manufacturing growth were electrical and optical equipment industries which increased by 14.6 per cent, the transport equipment industries which increased by 12.0 per cent and the machinery and equipment industries which increased by 12.7 per cent.

Comment

These figures are good and should be welcomed with a smile I feel. After the disappointing official figures for economic growth in the last quarter of 2010 these will be a positive influence on the first quarter of 2011 especially if the current trend continues into March which seems likely. For foreign readers it has become a British tradition to beat ourselves up over the apparent decline in our manufacturing sector over time, well for now we can stop as it is doing well! It may only be 13% of our economy these days but it may soon be 13% and rising.

In terms of economic theory I have discussed on here at times my theory that manufacturing/industrial production may respond to exchange rate moves which are “sustained”. This might mean that we are seeing some benefits from the devaluation of 2007/08 perhaps if companies now feel that the devaluation experienced then is now relatively permanent. As so much has changed since then it is virtually impossible to prove but I still feel that conventional economic theory is wrong in this respect and does not distinguish enough between temporary moves and those which become to be perceived to be permanent.

UK Producer Price Inflation

This has been a consistent problem for the UK economy and our numbers for this have consistently predicted the inflationary issues that we have been suffering from. Here is today’s update from the ONS.

Output price ‘factory gate’ annual inflation for all manufactured products rose 5.3 per cent in February 2011.

Input price annual inflation rose 14.6 per cent in February compared to a rise of 14.1 per cent in January.If you let the shock effect of such figures die down there are clear ways of analysing these numbers. As you can see the output measure’s annual growth is ahead of the level recorded by retail price inflation (5.1%)   and above that of our consumer price inflation measure (4%).So it indicates further acceleration in our inflation on the official measure. On an annual basis, all 10 sub categories recorded increases If we now move to the beginning of the price chain we can see that the position here is truly worrying as an annual rate of  14.6% is higher than that of (overheating) China! This may not be the end of it as it sometimes slips the ONS’s mind to point this out but last months figures were originally reported as being 4.8% and 13.4% and have now been revised to 5% and 14.1%. That is quite a revision for the input price figures.

Those of a nervous disposition may wish to look away now as earlier this month I looked at some figures for input price inflation produced by the Confederation of British Industry (CBI). If you look at the past record these have correlated quite well with the official numbers from the ONS and they are now showing input price inflation in excess of 20%. So rather than reducing it would appear that pressures are building up at the beginning of the UK price/inflation chain. and remember we are starting from a very high base.

Further Analysis

In reality the situation is in fact worse than this as the numbers have been “recalculated” by the ONS. I wrote on the 19th of November, the 14th of December, the 14th of January and the 11th of February  about a change in the way that the ONS calculates these figures. My conclusion is illustrated below.

This seems innocent enough but I have looked at the numbers for 2010 and this is its impact on the headline output number for produced price inflation for the months of this year so far. They are -0.3%,-0.4%,-0.5%,-1%,-0.5%,-0.7%,-0.8%,-0.5% and -0.6%.

I will leave you to draw your own conclusions! Official recalculations of inflation figures leading to a fall in reported inflation lead to a reduction in the credibility of the figures. Looking at the previous trends for this my calculations lead me to believe that on the old basis we would be reporting output price inflation of 5.9% this month and input price inflation of 14.9%.

Comment

I think that the figures are rather eloquent. We have an inflation problem which appears to be building further and at the beginning of the price chain the problem looks ever more serious. We also have a manufacturing sector which is going very well and an industrial sector which is doing well. The Monetary Policy Committee continues to forecast falling inflation and use phrases such as “temporary” and “one-off” when reality is quite different. We need a change in my view which was particularly highlighted by the appointment of a Goldman Sachs banker and ex-alumni of Harvard Business School to the MPC this week. It remains my opinion that it would be likely to lead to better policy outcomes if the MPC was directly elected. Frankly it would struggle to do much worse…..

UK Pensions Policy

There have been quite a few changes mooted this week and I would like to canvass readers thoughts on them. Not only from the UK as I am intrigued what the international perspective is on moving to a flat rate state pension and restricting public-sector pensions.

The reasons behind the Moodys downgrade of Spain and the implications for Portugal and Italy too

Today sees the second day of the Bank of England Monetary Policy Committee meeting and we will be told the results of their deliberations at mid-day. There is a consensus that the result will be no change in either interest-rates or the amount of Quantitative Easing and an example of this is the poll conducted by Bloomberg where 61 out of 61 economists suggested that policy will be unchanged.This gives me two thoughts. The first is that being a member of a “consensus” has been a risky place to be in the credit crunch era. The second is that as I wrote on Tuesday the 8th of March there is a “wild card” possibility of a rise today. So just to be clear I think that out of the 61 a few should have voted for a rise to represent the probability of it fairly.

My own view remains unchanged that our interest-rates are much too low and should have been raised some time ago. I started arguing on here for a rise in UK interest-rates ( because I was concerned about our inflation prospects back in November 2009) and wanted them raised to 1.5% then and would have raised them to 2% more recently. I wish to be clear that this is for a multitude of reasons which I have put on here several times ( I have a section on UK inflation prospects) and that even so policy will be expansionary something that often gets forgotten in the debate.My policy would be merely less expansionary than we have now rather than contractionary but in my view would help to put the UK economy in a better balanced position and to face the many risks going forwards. I gave some examples of the reasons why I believe in this policy on the 10th of February. I could put it another way, does anybody actually believe that the current policy of inflation denial is going well?

More Problems in the Euro zone

Portugal

Yesterday Portugal issued the bond which matures in September 2013 although as I pointed out their website did say 2012 in its update! However the price it had to pay was not good. The Portuguese auction saw the government pay 6 % for a 2 and a half-year bond which compares with 4.1 % in September. When you look at the interest-rate paid it is not even particularly good news that Portugal was able to issue the full one billion Euros of debt that was planned.

The reason for this is that if we look at what Portugal’s government has recently been claiming is that she pays an average interest-rate of 3.5% on her national debt which is according to them below the Euro zone average of 3.6%. This sounds impressive but misses out an important detail which is the marginal cost of debt which tells us what the prospects are for new issuance of debt. If Portugal could still issue at 3.5% she would not have a problem but as this bond issue has highlighted she cannot and remember she has had a lot of support from the European Central Bank (which is now estimated to own more than 20% of Portugal’s national debt) which means that even these inflated yield levels are lower than what they would otherwise be. Also the ECB has in effect created a false market in Portugal’s debt market which is exactly the reverse of one of the prime roles of a central bank as they are supposed to regulate and end false markets and not create them!

I have a theme that one of the ways of measuring a government bond market is to look at some of the shorter dated debt and compare it with the official interest-rate. As the official interest-rate of the ECB is 1% then paying 6% for a 30 month bond looks very unhealthy indeed to my mind. Furthermore Portugal has an expected government deficit of 20 billion Euros in 2011 and has a bond of 4.5 billion Euros expiring in April and one for 5 billion Euros expiring in June. So she cannot avoid having to issue new paper and whilst she has issued some already this year more and more of it is short-term bills and it is not long before they themselves will need refinancing. Issuing bills at a time like this is an attempt to “kick the can down the road” but in addition to the obvious problems of such a policy the can is not kicked very far. It will not be long before the Portuguese government has to revise the average interest-rate on its national debt upwards.

I do not intend just to point out the failings of current policy I have emailed my suggestions for what I feel would be a better policy to the Portuguese Minister of Finance.

Usually an inconvenient truth as described above is responded to with hyperbole and frankly rubbish by Euro zone officials but Portugal’s Secretary of State said this yesterday according to the Financial Times.

(The cost of borrowing is)  not sustainable over the longer term

Spain

Regular readers will be aware that I have written about the problems in Spain’s economy for some time and I have questioned the official view that everything is under control. To break things down Spain had a housing boom and now has a housing bust which has a lot of implications for her banking sector and in particular for her savings banks which are called cajas which have many similarities to UK building societies. The cajas are in a much weaker position than her listed banks and the official policy of merging the weakest with stronger ones had to my mind two major flaws. Firstly the stronger ones must be made weaker by the exchange. Secondly any such merger muddies the figures for a while and makes it hard to tell what is actually happening. Those of a more cynical nature will wonder if the second is the real reason!Furthemore Sapnish banking regulation has allowed even the listed banks to create special purpose vehicles and offer reduced interest-rates to those in trouble but many of these measures have a two-year lifespan which is now up or about to be up…

Moody’s downgrades both Spain and her bad-bank FROB ( Fondo de Reestructuracion Ordenada Bancaria )

Moody’s Investors Service has today downgraded Spain’s government bond ratings by one notch to Aa2 from Aa1. The outlook on the Aa2 ratings is negative

Okay Why?

 (1) Moody’s expectation that the eventual cost of bank restructuring will exceed the government’s current assumptions, leading to a further increase in the public debt ratio.

(2) Moody’s continued concerns over the ability of the Spanish government to achieve the required sustainable and structural improvement in general government finances, given the limits of central government control over the regional governments’ finances as well as the background of only moderate economic growth in the short to medium term.

There is also a side-effect downgrade for Spain’s bad-bank.

Moody’s has today also downgraded the rating of Spain’s Fondo de Reestructuracion Ordenada Bancaria (FROB) to Aa2 from Aa1 with a negative outlook as the FROB’s debt is fully and unconditionally guaranteed by the government of Spain.

Comment

I had been surprised recently when so many media commentators had taken the argument of the Spanish government that the cajas could be recapitalised cheaply in such a hook line and sinker fashion. Let me explain my thoughts. the problems of the cajas I have highlighted above and I agree with Moodys that refinancing and recapitalising them will be more expensive than Spain’s government forecasts. Let us hope that we will not be going down the same path as Ireland’s troubled banks who kept coming up with worse and worse figures which means in plain language that they were a toxic  combination of incompetence and willingness to misrepresent the true position.

Moving onto the Spanish government it has a record throughout the crisis of always doing the minimum possible apart from hyperbole where the Finance Minister Elena Salgado has usually done the maximum possible! But whilst its position and authority has weakened even in Spain there is a deeper problem. It only represents about 25% of Spain’s public expenditure with the rest mostly spent by the 17 regional governments. Of these very few publish accounts at all leading to concerns about overspending. As an aside this is rumoured to be one of the reasons why the main Spanish football clubs are able to finance some of the best players in the world as they appear to be subsidised by local and regional government. Sorry if that subject is still too painful for Arsenal fans as this fact probably makes it worse… So there is no real effective control mechanism over public expenditure in Spain and a shortage of public accountability in many areas. I think we already suspect what that is likely to mean.

Another factor gets forgotten because it feels like it has become a constant but we should not forget Spain’s unemployment rate which is officially recorded at 20%. I am afraid that private-sector reports challenge these figures and report an even higher number. So there is upwards pressure on the fiscal deficit from these numbers via higher social security spending and lower tax revenue.

Linking Portugal and Spain

The two stories above do have a link as God or nature got there first and put them on the same Iberian peninsula. As they trade substantially with each other one of the fears of the Euro zone crisis is that they drag each other down. With Spanish ten-year government bond yields now at 5.5% there are challenges for her in issuing new debt now as it is getting more and more expensive.

Earlier this week I was looking at some numbers which compared ten-year bond yields with a year ago. Spain’s had risen by 1.61% whilst the UK’s had fallen by 0.31% or put another way it would have been normal back then for Spanish government bond yields to be below those of the UK….

Just to be clear I have many criticisms of the ratings agencies as they are one of the areas most ripe for reform and maybe even closure but the detail of their reports is often helpful in analysing a situation. It is a shameful situation that one of the causes of the credit crunch has emerged with if anything a stronger position.

Italy

Whisper it quietly but Italy is getting more and more sucked into this business. Her ten-year government bond yield is right on the 5% threshold. Now there is the normal significance of getting what is called a new “handle” in the change from 4 to 5 should it be sustained but added to it is the fact that if it is sustained its behaviour will start to look like…..I will let you guess!

To put the significance of this the current “rescue” mechanisms have struggled with Portugal,Ireland and Greece and they would get a severe dose of indigestion from Spain but Italy would be far too much for them as they stand. As Euro zone politicians have responded very slowly during this crisis the European Central Bank must be both scratching its head and burning the midnight oil right now.

UK shop inflation rises again whilst Greek tax revenue falls in two rather familiar but officially denied trends!

One of the certainties of the post credit crunch environment has been signs of inflationary pressure in the UK economy. This should be at the top of the agenda of the UK Monetary Policy Committee as it starts its latest two-day meeting. This morning the British Retail Consortium (BRC) has updated us on the picture for shop prices in February.

Overall shop price inflation increased to 2.7% in February from 2.5% in January. Food inflation fell to 4.5% from 4.6% in January. Non-food inflation increased to 1.6% from 1.3% in January.

So we see yet another rise and whilst the BRC engages in a spinning operation in its report to in effect tell us up is the new down I spotted this about food prices.

This is demonstrated by the record proportion of groceries on promotion or discount, currently 39 per cent.

As promotions and discounts are by their nature temporary then that means that putting 39% of groceries on them has reduced food price inflation by a mere 0.1%. When they end therefore we can expect  further upward pressure on food prices and hence overall shop inflation. There is also an irony in the discounts being “temporary” as that it is of course what the Bank of England keeps telling us our inflation is! The biter bit perhaps. If we think back to the figures for shop sales in February which the BRC  produced yesterday which showed a fall of 0.4% compared with February 2010 we see a worrying picture of a fall in sales combined with a pick up of inflation. One of the themes of this blog has been the danger of stagflation and in the retail sector that appears to be exactly what we got in February.

Problems in the Euro zone: Bank stress tests

Last July a group of civil servants in the Euro zone published the results of their stress tests for Europe’s banks. In spite of criticism that was a version of the football terrace chant “You don’t know what you’re doing” these stress tests were lauded by Euro zone officials and politicians. Unfortunately the Irish banks which passed the test collapsed soon after! I guess the analogy for this is a bridge passing a safety test and then falling down.

Well just to prove that history teaches the Euro zone nothing banking stress tests are back and at present the plans are looking awfully familiar. Indeed there are several areas where the criteria have been relaxed such as the macroeconomic stress test and also the fall in the equity market which has been downgraded from a 20% fall to a 15% fall. If we stick to that measure for one second we can see the extent of the ill-logic as equity markets are now higher and a higher asset price means more risk. The Eurofirst 300 equity index closed at 1044 on the day of release of the stress tests and is now some 9.96% higher at 1148.

Perhaps the worst aspect of the previous stress test remains with us as assets which the bank plans to hold to maturity will not be included. An example of this would be a Greek,Irish or Portuguese government bond where the bank can avoid any impact on its figures by saying it will hold it until maturity. I am reminded of the City aphorism that a long-term position is a short-term punt that has gone wrong! As many of the Greek banks have holdings of Greek government bonds which are larger and sometimes much larger than their capital then such a ruling means that any results for them are meaningless.

Comment

It is a sad thing to report but the previous bank stress tests did buy the Euro zone some time. Perhaps a couple of months or so before Ireland started her banking inspired spiral downwards. Why is this so sad? Easy after all this time it appears that buying a couple of months again is the best the Euro zone can come up with.

I am of the view that the concept of a stress test is at best a guide and should be treated as such. The Euro zone version has proved not even to be that and should be treated accordingly.

More Woe For Greece

There have been increasing rumours that Greece will issue some “diaspora” bonds. These look like they will be offered in US dollars and there have been claims that they may offer as little as 4% yield. The original plan was to issue around US $3 billion of these. The concept is that they would be sold to Greek expatriates of which it is estimated that there are as many as Greece’s actual population. Now to my mind they would really have to love the motherland to allow themselves to be taken advantage of by these proposed terms! Would Sir or Madam prefer 4% to 12%?

The truth is that the Greek government has promised regularly that it will return to issuing bonds in 2011. As conventional issuance at present price and yield levels would confirm Greece’s insolvency there is a clear flaw in such a plan. However they appear not to be bothered by such (petty?) inconveniences such as reality and are trying to come up with something which looks different and presumably will fool people enough that they might buy some of it. This has happened in other countries in one form or another as for example the War Loan stock in the UK has never been repaid. However whilst War Loan turned out to be a type of misrepresentation it was not evident at the time of sale!

Greece does issue bills and issued some yesterday and it did not go particularly well. Just to clear up the difference between a bill and a bond then bills are usually of 12 months lifespan or less and bonds are of longer maturity although paper with a lifespan of between 1 and 2 years can also sometimes be called a bill. As the debt issued yesterday was of 6 months maturity then it was a bill and Greece raised some 1.62 billion Euros. There the good news ended as she had to pay 4.75% rather than the (already inflated) 4.64% she had to pay in February.

The size of the bill issue was increased because Greece has higher debt repayments to make this month and this is an ominous foreboding for her. Apart from the increasing cost of issuance she does have two inflation linked bonds and inflation is over 5% so they are proving expensive too. This is also a problem for the UK as we also have inflation-linked bonds representing more than 20% of our national debt and inflation is high here too. Greece has a much more genuine case for ruing the increase in consumption taxes such as VAT as she has had several goes at it and they will have impacted on her inflation rate.

The net result of this was that Greek ten-year government bond yields rose to close at 12.85%. At times her government bond market has got so frenzied and confused it has been hard to tell exact yields but this is about as bad as it has got and this now includes the period running up to her “rescue” although some reports had the yield over 13% briefly. If we put this another way and go back one calendar year then Greek ten-year government bond yields are 6.82% higher now than they were then.

There is a worse problem as her two-year yields are now 16.25% which is some 10.83% higher than a calendar year ago! Now the official European Central Bank interest rate is 1% and I use the difference between official rates and short-term bond yields as a yardstick. For example to illustrate the point even after last weeks rises in yield after the ECB announced it is considered an interest-rate rise German two-year bond yields 1.73%. So the gap between her and Greece is some 14.52%.

Now here comes the rub as two-years is well within the scope of the “rescue” programme. So the return of the money is in effect guaranteed by the European Central Bank the International Monetary Fund and the European Union. However at a price of 79.8 for a bond on which you should accordingly get 100 in only two years sends its own message as to the credibility of this “rescue”. This is my message to those prone to hyperbole in support of the “rescue”, how much of this bond do you hold?

Greek finances: tax revenue disappoint again

The Greek newspaper Kathimerini reported this yesterday about Greek budget revenues.

Compared with the first two months of 2010, revenues declined this year by 9.2 percent…………the shortfall exceeding 870 million euros after the February goal was missed by 595 million.

This reinforced a point made in the downgrade issued by Moody’s (point two from my update from Monday the 7th of March) . It also reminds me of the furious sounding rebuttal of the downgrade issued by the Greek Finance Ministry.

Furthermore, Moody’s announcement refers to the delay in the rebounding of budget revenues, yet does not take into account the increase in revenues.

Whilst they are talking about 2010 they must have known their own figures for 2011…..

If you look at the Kathimerini article some things look awfully familiar to followers of the Greek crisis. The emphasis is mine for a bit I considered rather extraordinary (isn’t Greece supposed to be checking more not less?).

It appears that the revenue problems arose due to poor calculations by the Finance Ministry while drafting the budget, a reduction in checks and the go-slow tactics of some tax officers in protest at recent salary cuts.

Comment

Much of this is familiar at a time when we are supposed to believe that this is in effect the new improved Greece. As figures emerge they are contradicting the official story more and more. Looking at the detail of the figures the VAT take has in fact improved by 7.1% this year but this only means that other taxes must have fallen even further than the headline number suggests. I write this sadly but with the latest annualised economic growth figures showing a fall of 6.6% these tax revenue figures are not a surprise and I worry that things could get even worse.

Portugal

Today the emphasis moves to Portugal as she is planning to issue some 1 billion Euros of a two and a half-year bond. The problem is that her ten-year bond yield closed above 7.6% yesterday and frankly there appear to be few signs of buyers of her paper/debt. It remains to be seen whether the European Central Bank will step in again and in effect become a “buyer of last resort”. No doubt there will be some arm-twisting to get some institutions to buy…..

Just as a matter of record I emailed the Minister of Finance with some suggestions as to how I feel the situation for Portugal could be improved last Friday. Should I get a reply I will let you know.

Update 11:30 am

The website for Portugal’s debt agency is a little confused about the new bond as on one bit it says 2012 and on another 2013 as the maturity of this bond…………..

Will the US Federal Reserve end its asset purchases (QE2) early? Or give us QE3? And will the Bank of England raise interest-rates?

At the end of last week we saw the European Central Bank take centre stage with its threat/promise to raise Euro zone official interest-rates at their April meeting. If you translate their code then you would now think that a rise in April from the current 1% to 1.25% was now more likely than not, although in the current volatile environment (North Africa for example) there is no such thing as certainty. One thing that the “shock” effect of their announcement did remind me of was the tactics of the German Bundesbank which loved to do the unexpected and shock markets in the 1980s and 90s. They always had you on your toes. I suspect this tactic may well be related to the current Bundesbank President Axel Weber announcing he will not stand to be the next ECB President with the ECB Governing Council feeling its credentials need a boost as the standing down of “Darth” Weber had sent the reverse message. This led to the following question in my mind.

What will the other central banks do?

As China is involved in tightening anyway there is little change for her. Japan is still mired in disinflation so again little likely change. Indeed from the point of view of Japan the rally in the Euro exchange rate which this statement produced is likely to be welcome and frankly they would like more of it! As Japan has an overvalued currency and has exporters struggling with its inflated level the Bank of Japan will welcome this new policy and an exchange rate of 115 Yen to the Euro. So in spite of their own monetary policy still being very loose and in fact pretty much the opposite of what the ECB proposes it may well raise a smile in Tokyo.

The US Federal Reserve

Here we find another central bank with a loose monetary policy. With interest-rates set in a range of 0 to 0.25% and asset purchases planned of US $75 billion per month ( until June 2011) policy could hardly be much more expansionary. Will it now change? The last 24 hours have seen 2 voting members of the Fed give speeches and one be interviewed on CNBC. As the debate starts with will QE2 (the asset purchases) now end early let us start with the most “hawkish” of the three Richard Evans of the Dallas Fed.

Richard Evans: President of the Dallas Fed

Mr.Evans first lets us know his view on the current policy known as QE2

There are some, including me, who argued against the last tranche of insurance we took out in committing to buy $600 billion in U.S. Treasuries between last November and the end of this coming June as we were simultaneously purchasing additional Treasuries to make up for the roll off in our mortgage-backed securities.

Okay Richard why do you think that?

There was a strong feeling among those of my policy persuasion that we had already sufficiently refilled the tanks holding the financial fuel businesses needed to drive their job-creating machines. They felt that by being too accommodative, we might run the risk of planting the seeds that could germinate into renewed volatility, speculation and inflation, or give comfort to a government that for far too many congressional cycles has fallen down on the job by spending and borrowing and committing to unfunded programs with reckless abandon.

Indeed he goes onto tell us this.

I do not, however, feel that further monetary accommodation will speed the process. It might well retard job creation, should it give rise to inflationary expectations or, worse, imply that,……. we have now been compromised and become a pliant accomplice to Congress’ and the executive branch’s fiscal misfeasance.

Comment

If you combine this speech with previous ones by Richard Evans it is plain that he is no fan of what is called QE2. However I see no sign in the speech of any hint that he will vote to stop it. Indeed rather oddly he actually voted in favour of it at the last FOMC meeting! Quite how he managed that feat of intellectual gymnastics I am still not quite sure but he did. Indeed he even mentions the factor that to my mind means that QE2 and QE-lite are likely to continue until they expire.

But it is worrisomely clear that the task of putting millions of unemployed and underemployed Americans back to work will take an anguishing amount of time.

Members of the FOMC are referring to this fact so often these days it makes me wonder more and more what will happen when QE2 and QE-lite end in June. If we saw the picture for unemployment and employment deteriorate there is little doubt in my mind that the FOMC would then vote for a new round of asset purchases which would no doubt be called QE3. As I expect asset purchases to suffer from the law of diminishing marginal returns there would then be serious problems as QE3′s very existence would already imply that QE,QE-lite and QE2 had not succeeded.

Just to be clear Richard Evans assures us that he would not vote for a QE3 but he previously said he was against QE2 and then voted in favour of its continuation. So here is my message to those who expect QE2 to end early. Who is going to vote for this if not Richard Evans? Of course circumstances may change but as we stand there is little sign of the improvement required.

Charles Evans: President of the Chicago Fed

Charles Evans who apparently likes to be called Charlie (sometimes you couldn’t make it up…..) was interviewed on and looking at the transcript and trying to make sense of what seem at times to be confused ramblings we get this.

That’s part of my rationale for why $600 is a good number for our asset purchase size. I– when we started this, I might have thought that, you know, $600 was a good start to the program and we might have to do more. It’s looking more and more to me that $600 is a good number for this.

I am giving him the benefit of the doubt and assuming he is aware that it is US $600 billion for QE2 rather than an amount some US $599.999994 billion smaller! However the message is clear to my mind, Charlie has only thought of more so far and not less.

Dennis Lockhart

In a speech which has now disappeared from the Atlanta Fed website President Lockhart told us this.

My first inclination is to be very cautious about extending asset purchases after June…………….Given the emergence of new risks, however, I prefer a posture of flexibility as regards policy options.

Comment

I think that the US Federal Reserve  is sending out a message that its polices are working well and that we can expect economic growth of 4% this year and 4% in 2012 too. Accordingly this makes people wonder if the current programme of asset purchases might end early. Personally I feel that the scenario presented is rather rose-tinted and that one factor will worry FOMC members. What if they turn of the QE2 and QE-lite taps and the stock market and asset prices immediately go into reverse? What do they do then? Well might they worry in my view.

If you take my suggestion then any dip in the economy makes a further round of asset purchases possible and then probable depending on the scale of the dip. As the FOMC talks more and more about unemployment it is my view that these figures as they develop in the spring and summer of 2011 will in effect be setting US monetary policy.

The UK and the Bank of England

Here we have a central bank with a clear inflation problem. The officially target inflation index for consumer prices or CPI is at 4% which is double its target and its predecessor RPI is at 5.1%. As the equivalent inflation rate in the Euro zone is only 2.4% it is clear that were the ECB to be in charge of UK economic policy we would already have seen not only a rise but rises in interest-rates.However the Bank of England is in what psychologists would call denial and its policy could be lampooned as “inflation I see no inflation” as like Nelson they put the telescope to their blind eye!

At the meeting on Thursday there is a chance that the Bank of England will raise interest-rates as at the last meeting 3 of the 9 members voted accordingly. So it would take only 2 more votes. As an aside I wonder if it could be 4-4 this time apart from the Governor who would presumably vote for no change. However I think that whilst possible it is still a low percentage chance.

Why?

1. The Monetary Policy Committee has often placed great store on economic growth figures. The latest official figures showed a fall of 0.6% in Gross Domestic Product or GDP for the last quarter of 2010.

2. More recent economic data does mostly show a return to growth but some elements have been weaker. For example we had estimates last week that whilst manufacturing was doing well the growth in services had slowed a little. Today we see that the British Retail Consortium  is reporting a drop in sales of 0.4% in February. So whilst the measures released are unreliable they may give an excuse not to raise interest-rates. We will get new figures for industrial and manufacturing output on the day of the decision so we will have to wait for them. some forecasters have been reducing their growth forecasts for 2011 presumably on the basis that 2010 ended weakly. (Personally I think that this is a mistake as we do not yet know with any clarity what did happen at the end of 2010 as there are many contradictory figures).

3. The Bank of England has invested a lot of its remaining authority and credibility in telling us that inflation is “temporary” and a result of “one-off” factors. Accordingly a policy change would be at best embarrassing….

A Wild Card

The wild card is that MPC members must be aware that they are attracting criticism which is rising and that their policy is becoming an ever larger embarrassment. Looked at like that then just like a wild animal which is cornered their behaviour is hard to predict and so I will be awaiting noon on Thursday!

A New Member of the MPC

If you were from Mars observing the UK over the period of the credit crunch you might think that it might be best to avoid appointing a banker at this time and that considering the company’s dodgy involvements around the world such as Greek debt derivatives it would be particularly wise to avoid appointing someone from Goldman Sachs.If you were willing to ignore that you might think that as ex-alumni of Harvard Business School were implementing policies which were under fire it might be best to avoid them too……… So I guess  our Martian is currently wondering about this appointment!